Why Eliminating The Mortgage Interest Deduction Won’t Matter

When the Obama administration proposed that we lower the deduction for mortgage interest for those in the 33 and 35% tax brackets, you would have thought that he demanded people give up their first born.  But if we step back for a minute and get away from the hysteria that is sweeping the airwaves, we will realize that giving a tax break for mortgage interest does nothing to benefit anyone except mortgage bankers and real estate brokers; it certainly does not benefit home buyers.

My economic training tells me when we subsidize demand, we will end up driving prices higher.  When deciding on a price to bid for a house, a rational person will make calculate how much they can afford to spend every month on principal and interest (I will leave aside insurance and property taxes).  The mortgage interest deduction merely subsidizes that interest by allowing the taxpayer to deduct the interest paid from their income.  This deduction will save the buyer the amount of interest they paid multiplied by the taxpayer’s marginal tax rate.  The net result is that the rational home buyer will put that savings into his original calculation of how much they can afford to bid on the house.  The bigger the deduction, the more the buyer can afford to bid.  Rationally, all buyers will do the same calculation, and bid up the price to take into account this savings.  The net savings from this deduction will simply be added to the price the home buyer will bid and take away the savings from the deduction.  Therefore, the home buyer will be no better off than if there was no deduction.   However, more demand should lead to more supply in the housing stock (thanks to my colleague AW for pointing this out to me).

So what does the interest deduction actually do:

  1. Encourages leveraged purchases of highly illiquid assets.  By giving a subsidy to mortgage interest, the Government is incentivizing people to purchases homes using debt.  Most people, when they buy homes are leveraged 4 to 1 (if they purchased with 20% down).  The leverage can easily wipe out any equity a person has in their home if the value drops (as we have seen all too well in the last 2 years).
  2. Drives up the price of homes in a proportional amount to the tax savings from the deduction.
  3. Transfers wealth from buyers to real estate brokers who get a commission based on the sale’s price–the higher the price of the home sold, the higher the commission.
  4. Transfers wealth from buyers to mortgage bankers by encouraging the use of debt and more of it to purchase homes.
  5. The only home buyers who actually benefitted were those lucky enough to have owned a leveraged home just prior to when the law was enacted, because they bought their home when prices did not reflect this subsidy.

So what would happen if we eliminate the tax deduction:  home prices would fall in a proportional amount to the lost tax savings.  This would leave future buyers no worse off than if the subsidy had still been there.

My proposal:  allow the deduction to continue for current home owners but eliminate for all future buyers.  Is this completely fair, no.  This will decrease home values for the current home owners.  But it is more fair than to eliminate the subsidy right now where most, if not all buyers, relied on that subsidy when they purchased their homes.

In a future post, I will share my thoughts on why purchasing a home is actually one of the dumber investments a person can make.

Update: As one of my colleagues, Trevor, points out, even though the seller of the property will get less than they would had the deduction still been there, this loss will be offset by the benefit of being able to buy another home at a lower price (assuming they do buy another home).

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3 Responses to “Why Eliminating The Mortgage Interest Deduction Won’t Matter”

  1. Peter Drum Says:

    Hey Matt!

    Good to see you online espousing your crazy views! Kidding.

    You forgot a MAJOR reason for subsidizing mortgage interest. Even with movement in the market, real estate is still one of the most stable investments a person can make. Yes, Wallstreet totally messed that up with mortgage backed securities, but the fact is that other than a few markets like Miami and LA, most folks have only lost 10-15% of the value of their homes versus 40-50% of the 401Ks. That is a big different. Homes stabilize many families. They are more secure than renting and actually spread out the ownership of equity. That is a key to having a functional middle class.

    Even with the harm that has been caused to real property values, a person who was heavily invested in real estate over the last 20 years has fared better than a person heavily invested (on average) in Wall Street. The tech boom and bust, the mortgage backed securities boom and bust, the commodities boom and bust…

    Now, I don’t have a big problem with Obama wanting to change the deduction for top earners, but we should recall that the mortgage deduction is the single biggest tax deduction that the middle class recieves, and the one that the rich can least take advantage of. For example, my house represents a far larger portion of my net wealth than Bill Gates house represents for him.

    The other thing that you see in areas where home ownership increases is the civic engagement improves. We become more involved in politics when we own a piece of the action.

    Cheers, Peter

  2. Bethany Says:

    I agree completely that the deduction does not make sense from an economic point of view (although I hear the point about civic involvement, stability, etc.), but, the big problem with eliminating the deduction now is the effect that it will have on all those who, relying on the deduction, bought a house. Now, certainly we don’t want people to buy things they can’t afford, but I think it’s reasonable to take into account the current tax structure when evaluating affordability. If we eliminated the deduction now, there would be another wave of foreclosures (not triggered by bad loans or unemployment but simply by cash flow problems), and I’m not sure that’s what the economy needs right now. There must be a way to make the tax structure more rational while avoiding this consequence, but I’m not knowledgable or creative enough to come up with it.

    Great post!

  3. FolioGuru Says:

    The reality is people who made smart investments in real estate, particularly homes, have done better than the market over the same period time (long term).

    If you include the tax savings, which helped pay for a smart investment in home (one where you did not leverage everything), the ROI is quite remarkable.

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