Dec. 1, 2010
In our continuing series on looking at the economics of housing, we'll look at today the economics of the home mortgage interest deduction.
It's a good topic for now, because since our federal government has had a spending problem for about 30 years or so, they are looking at new ways to raise revenue (taxes) and this one is on the table as getting axed. (See the bottom for more on the feasibility of this).
What is the home mortgage interest deduction?
The home mortgage interest deduction is one of the more interesting tax breaks in this country. I don't know how many other countries do it, but it does have some interesting effects.
First off, let's make sure we all know what it is. (And in the interest of full disclosure, I'm not a tax guy, so this is more of a laymans version, OK? Want the real skinny? It's here.) It's a FEDERAL Tax deduction. So it only applies to the taxes that you pay on your federal returns, and also, as a deduction, it reduces your AGI, your adjusted gross income. And it's only about the INTEREST that you pay, not the entire mortgage payment.
This means that if you have a standard, reverse amortized mortgage (that's 99.9% of you), you pay a LOT of interest at the beginning, and virtually none at the end. So people that stay in their homes and don't refinance see less and less benefit every year from this deduction. Overall, it's often said that this is a deduction to encourage home ownership, but based on the nature of the deduction, it's really an incentive for home buying, and refinancing. (Some people who stay put will re-finance a 30 year loan into a 15 year loan, and a benefit of that would be to increase that interest again for a few years.) Again, it doesn't significantly benefit those who have small or no mortgages, as there's very little interest to deduct.
But for most of us, especially in the northeast, where housing is pricey, it's a very important deduction, often allowing us to spend thousands more on our house instead of thousands more in taxes. And I think it's worth noting here too, that those in areas where housing (and therefore mortgages) are more expensive, will be the most impacted. For example, if you live in Detroit, and owe $100,000 on your $120,000 home, the interest for the entire year is about $6000, or probably about $1500 in tax savings. That's a bite for sure. But a homeowner in New England who owes $300,000 K on a $350,000 home is looking at about $15,000 in interest, and about $4000 in new taxes. That's a real bite, for sure.
Impacts from eliminating home mortgage interest deduction, as proposed by Simpson Bolwes Report
So, let's identify some impacts from scrapping the deduction.
1) Housing in the North East will decrease in value.
Let's face it, without the deduction, the number of buyers will decrease, without the tax deduction people will have to borrow less and both those things will pull down prices. No if's, and's, or but's about it. How long (and how much) they'll go down depends on how they change the tax, and will likely be a matter of some debate, but in the example above, if you wanted to recoup the $4000, you'd have to borrow about $200,000 K instead of $250,000 K, and that means your 300K house is now worth 250K. Some people will certainly give up looking to purchase a house resulting in...
2) Rents will increase.
Many people will see that it might be smarter to rent than to own, and they'll rent. I would expect Nationally home ownership rates to fall.
Impact on how much people will borrow as part of the mortgage
3) Mortgages will decrease
If you can't offset the interest, people will borrow less as noted in the example above. So mortgages will go down, with prices. Much of this is going on currently already, and it's called de-leveraging, which is a fancy term for owing less money than you did in previous years. Unfortunately, de-leveraging is very painful for an economy, (as we have seen), and arguably the most painful of any type of activity other than deflation.
4) More Renters.
Eventually, the new math of owning a house will work its way into the market, and things will stabilize. With more renters though, there will be more apartment buildings, and fewer people invested in their community, which, I think, is really bad and arguably worse than all the other issues put together. It's a known fact (based on actuarial tables) that on average, owners take better care of their property than renters, so this is a bigger deal than one might expect at first.
Feasibility of Congress Eliminating Home Mortgage Interest Deduction
Feasibility: For those that have been paying attention, the Fed has really seen housing as the way to "heal" the economy. They have done just about everything they can think of to slow down foreclosures (forcing banks to refinance bad loans), spur buying (low rates, treasury buying, Fannie and Freddy loading up on loans), and anything else related to housing. They obviously believe (Ed Note: Me too!) that if they can shore up housing, they can restore confidence, reduce loan losses, and get everything moving again like we were all used to prior to 2007. Based on that, and the impacts of killing the mortgage deduction, I'm pretty sure Mr. Bernanke would do anything he could to stall this particular method of raising taxes. I'm not smart enough to say that it would be catastrophic to the housing market, but, it would be bad, and probably much worse than people think, because housing is so illiquid. (If you had to, phasing it out over 10 years would be much smarter, IMHO). It should be noted, that in general, I'm not a huge fan of "tax breaks" for any one particular activity, and I think that the interest deduction could be improved, but overall it does what it should - artificially increase home ownership, which is better for communities, and by extension the country. A man's (or woman's) home is his (or her) castle, and we tend to take pride in it, and that's a good start for a community.
OK. Your turn. See that comments section below? Your chance to sound off on whether it's stern medicine for a tough time, or utter foolishness.
