Personal Finance 

What if the mortgage interest deduction didn’t exist?

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Welcome to the first edition of our What If? series, where we wonder aloud and ponder some of financial life’s great mysteries. This first edition will take a look at the mortgage interest deduction, one of our most popular tax deductions, because it was featured by the deficit reduction commission just last week.

First we’ll take a brief look at the deduction itself and then discuss what if it didn’t exist, followed by what if it went away? I think the two are vastly different questions and I hope you’ll chime in with what you think.

Mortgage Interest Deduction

The mortgage interest deduction is one of our hallowed tax deductions and one of the main reasons why so many people itemize their deductions on their income tax return. You can claim any mortgage interest taxes as a deduction if you are legally liable for the loan and the mortgage was less than $1,000,000. If you have more than one mortgage, you can deduct it as long as the total mortgage amount is less than $1 million. There are other rules and exceptions but that’s the gist of the mortgage interest deduction.

What If It Didn’t Exist?

The question of what would happen if it didn’t exist differs from what if it goes away, which is what the deficit commission is recommending as a way to reduce the deficit and debt. If it never existed, then home values wouldn’t be as high as they are now (even now, after many markets have fallen following the economic crisis).

All examples in this article assume the home buyer or home owner is in the 25% tax bracket.

The mortgage interest deduction acts as a subsidy for people who buy homes with a mortgage loan and it was designed with that purpose in mind. If you can afford to pay $1,000 a month on a 5% 30-year fixed mortgage, then you’ll be able to buy a house that, after closing costs and a downpayment, leaves you with a $187,000 mortgage. That first year, you’ll pay $9,297 in interest, of which you’ll get $2,324 back, or nearly $200 a month. In reality, you can afford more than $1,000 a month because of the tax deduction. You can actually afford a home that’s closer to $1,200 a month – or a $220,000 mortgage.

See how the deduction, which puts a little money back into your pocket, has now enabled you to afford a larger home?

Since the deduction has existed for a very long time, coupled with other housing affordability programs, it has had the effect of raising the tide for all home values.

What If It Goes Away?

To the commission’s credit, they are recommending that it be replaced with a 12% non-refundable tax credit available to everyone and the mortgage size would be capped at $500,000, down from $1 million. Interest on second homes and home equity loans would be excluded. They aren’t recommending that it be cancelled entirely, which would surely hurt the housing market in a time when it’s weakest.

As we saw in the earlier section, that the tax deduction raises the value of homes, removing it would have the opposite effect. Without the subsidy, someone who would consider a $220,000 mortgage would now only consider one at $187,000.

This all assumes, of course, that the majority of homeowners consider the deduction, and do this math, prior to buying a home.

What do you think?

{ 48 comments, please add your thoughts now! }

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48 Responses to “What if the mortgage interest deduction didn’t exist?”

  1. Grant says:

    I think that if this credit were phased out it wouldn’t be as clear cut that people would shift from owning to renting as most likely the rental cost would rise as well due to the mere increase in demand. It would be nice to have the markets dictate the prices rather than being distorted by a government subsidy. All in all, I think people need to recognize a house as their home and place to enjoy and live in; not as some asset that they monitor the value as if it were on an exchange. If this were the case I think the housing bubble would have been tempered if not completely avoided. Owning a house is not a right and I don’t see why our country was so fixated on the idea of home ownership. I think it is nice to have a place you can call your own but all in all I think it is a choice that should be decided free of government incentive.

  2. Shckr7 says:

    My opinion, regardless of whether you believe in the mortgage deduction or not, is that we need to settle on a tax code and stick with it. Investors HATE uncertainty.

    It amuses me, in a not so funny way, how we continue to propose new tax codes during election years…….

  3. justin says:

    I hope they end it soon. I’m tired of the rest of America forcing its values down my throat. Tired of politicians who make references to families and home ownership as if those who partake are morally superior to those of us who don’t and are not interested because they’ve done the “right and proper thing” according to the strong socially (and economically, with credits like this) enforced Christian or otherwise ‘values’ with which I do not agree.

    If other people have home ownership as their highest value and mine is travel, why can’t I have a tax credit for plane tickets? Again, forcing their vaules down my throat. Hate it.

    • jim says:

      What an excellent arguement! It’s funny that people seldom see it this way, and yet there it is. What is your “values” are my “faults”. One man’s treasure is another man’s trash.
      I own my own home, but would happily give up the mortgage interest deduction. Especially if it meant a much simpler tax code.
      The mortgage interest deduction only has value to developers and realtors, who can use it to sell bigger houses to people who don’t really need them.

  4. Terry says:

    “Since the deduction has existed for a very long time, coupled with other housing affordability programs, it has had the effect of raising the tide for all home values.”

    And what is the effect on renters? How many are priced out of homeownership? How many billions of dollars are redistributed from renters to homeowners through the tax code?

  5. djn says:

    I think a change in tax structures would change housing decisions that people make. Large homes would be less attractive for many people. People might be less willing to fund local government and education through property taxes. Seniors who are carrying a mortgage would have less reason to continue being home owners.
    Further collapse in the housing market will have a negative impact on all Americans, whether or not you own a hme. So the system should be changed carefully and thoughtfully.

  6. bm says:

    Ridiculously low interest rates also contributed to inflated housing prices. Too much gov involvement (including the mortgage deduction).

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