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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. Wow, would that mean housing values would drop? Which would further devastate the market…

    As far as what it would mean to me personally, well, I would start focusing on paying down my mortgage more quickly.

  2. cubiclegeoff says:

    I’m not sure most people consider the deduction when purchasing a home. There may be some real estate agents that push the point, but unless you know about the tax code and your tax bracket (I’d say most people don’t), then you couldn’t really put a dollar figure to it. I do think that if the deduction didn’t exist, there is a possibility that home sizes wouldn’t have increased as much as they did. I also think homeownership wouldn’t have become such a major issue.

  3. cubiclegeoff says:

    I also think home prices still have more to do with supply than anything else. In places with low supply (some areas on the coasts), prices wouldn’t be impacted much, if at all, if the mortgage deduction was gone.

  4. Traciatim says:

    Sure, home prices may drop, but I doubt ownership rates would change that much. In Canada we don’t have the mortgage interest deduction (except on investment properties) and we have similar ownership rates, or possibly even higher. We are only allowed to deduct interest on loans specifically taken to create investment income, which is generally rents, interest, or dividends.

  5. JC says:

    the other issue is that the interest deduction only helps those who itemize their deductions. Those who take the standard deduction do not get these benefits.

    • Scott says:

      I don’t think people really know this until their first year of ownership. If you have a $150k loan @ 5%, that’s $7,500 the first year in interest expense. Unless you have OVER $3k in other deductions, say, charitable contributions, you do not get a penny if you are married.

      Our kids took a modest $100k home and do not get a red cent as their loan is $85k @ 5.5% and only pay $5k in inerest at most…

      I wish there were a simpler way to pay for services provided and stop this Mickey Mouse deduction here, tax break there junk. That would make it so simple for the normal person. The laws as they are, are likely for the over-extended, businesses, industries (IRS, attourneys, insurance).

      • jim says:

        “Amen” to that!
        There is a simpler way we could go, a national sales tax.
        Everyone could understand and know exactly how much the government charges, as they would see it every time they bought something.
        No one would ever have to fill out a 1040a sched d etc.
        Tax lawyers and accountants and lobbyists would hate it!
        All that lost productivity finding tax deductions and calculating and reading tax code would be free to do good things, like sciences and bridge-building and yes, even art!
        Our economy would get much better because of higher productivity.
        Corruption would hit an all-time low because there wouldn’t be any complicated tax code hiding who’s getting over (think about oil subsidies hidden in tax credits).
        It would free up legislators to do their jobs formulating GOOD laws instead of wasting time on manipulating the tax code for some lobbyist or campaign contributor.

        Too simple. Too good. So I guess it won’t happen.

  6. Courtney says:

    I don’t think most people take this into account when buying a home, because most people prefer to get large refunds instead of adjusting their withholding. Getting 25% of your mortgage interest back once a year doesn’t change most people’s monthly budget.

  7. Anonymous says:

    In other countries around the world suffering from a property bubble this deduction does not exist. So even though property prices would suffer ( or would not have gone up quite so high as they had ) it would not have made a marked difference in the market. Removing it is a good idea but does need to be done gradually.

  8. Texas Wahoo says:

    It certainly would have changed my decision to buy a house earlier this year, but not so much in the way you are suggesting. I didn’t buy more house because of the deduction, but I did factor it into the decision on whether to continue renting or buy a house. The cost of the mortgage is higher than the monthly rent we were paying, but the deduction makes the house a little bit cheaper.

    “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.”

    Do you know how it would work if you have a mortgage that started over the limit but you pay down enough to put the current mortgage amount below the limit?

    • freeby50 says:

      Texas, The $500k figure wouldn’t be a pass /fail test. It is the amount of the mortgage that would be eligible. So if your house is $501k, $600k or $2.5M then you would still qualify but only for the $500k amount.

  9. zapeta says:

    I really don’t know how many people figure the mortgage deduction in to their home buying power. People I know who own homes either don’t have enough deductions to itemize or if they do they didn’t figure the potential for a deduction in to their purchase.

  10. freeby50 says:

    I think the impact of the deduction is exaggerated.

    30% of people rent. 30% of homeowners own their homes outright without a mortgage.
    That leaves about 50% of people who have a mortgage at all. LOTS of those people have mortgages with lower balance. Many people don’t have enough to itemize their taxes even with the interest on a mortgage. At least 20% of home owners with mortgages don’t itemize. So we’re looking at probably a maximum of 40% of people who get any benefit from mortgage interest deduction. Among those people I’m sure a lot of them get a marginal tax benefit.

  11. BargainCalculator says:

    It looks like your calculations don’t take into account the standard deduction. For single taxpayers it’s $8,400 in 2010 which would make the mortgage deduction only $897 more than the standard deduction (you can’t take both.) This is about $20 a month in actual tax savings, not $200.* For married filers, their standard deduction is actually higher than the mortgage interest so they would be losing $2,303 in deductions.*

    * I am assuming they didn’t have other things to itemize and deduct which may or may not be the case for a particular taxpayer.

    • Jim says:

      The tricky part is that we almost all pay state income tax and property taxes (those in no-state income taxes states just hush up! :) ), both of which are deductible only if you itemize (you can get up to a $500 deduction for property taxes if you claim the standard deduction).

      • freeby50 says:

        Yeah its not just about whether or not your mortgage intesrest is more or less than the standard deduction. You also have to look at all the other itemizable items: state income tax, property tax, charity etc. For some people those other items are already more than the standard deduction.

  12. Dean says:

    I haven’t paid enough interest to qualify for the deduction in several years, long before the mortgage was paid off. I wonder if that flat 12% would help me as a homeowner without a mortgage? (and don’t hate on me, I’m not rich, just frugal)

    • Scott says:

      Don’t care if you’re rich or frugal…I respect anyone who pays off their home. Less tax monies going to you and less interest going to banks is a good thing for the economy.

  13. Vik says:

    This is huge in California. We bought a 500,000 house in 2009. Annual interest is 16,000 for the 30 yr fixed mortgage. Also, property tax is a little over 9000. We’re both in 28% tax bracket.

    • Scott says:

      You are in my neck of the woods. I just can’t drop $500k on a home…hurts too much.

      Paying $16k to get back $5k costs you $900 / month after tax “break”. I rent a home for $2100 without any responsibility of taxes, maint, gardner… in South Encino (very nice $700k+ homes).

      Just can’t justify it. I do want to, just can’t “pay” for the satisfaction of owning.

      Used to own in TX, so I have a clue on the pride / satisfaction of owning…

      How much is your note? I’m guessing $3k…

  14. live green says:

    I don’t think you should use this in your calculation for whether you should buy a house or the cost of a house. It will most likely cause you to overextend your budget and rely on the deduction to afford the house. What if a large expense comes up or the deduction does in fact go away?

  15. PokerCat says:

    In the long run, the tax should be eliminated. Although I agree, an elimination must affect the price of homes, and therefore affects consumers’ bottom line, it’s also a subsidy that benefits banks. It lowers the cost of mortgages, at the taxpayers expense.

    With the savings, you could either cut taxes, lower the deficit, or increase spending with the savings (depending on your political leanings).

  16. Anonymous says:

    I can tell you that if they do away with the deduction that it will certainly influence my decision whether to keep or sell both my primary and/or rental properties. I am so far underwater on both that it would be pointless to keep either one. At the end of the day, it is a business decision whether to buy or rent; if the government changes the rules of the game, I can tell you that I won’t think twice about walking away from both properties.

  17. govenar says:

    In California at least, I think lots of people depend on this deduction; i.e., without it they wouldn’t be able to afford their mortgage payment. But I agree that if it never existed, house prices would be lower. It seems like all this deduction ended up doing was causing more inflation.

    Since I haven’t bought a house yet but probably will in the future, I want house prices to go down, so maybe it’d be good for me if this deduction was removed; but then I’d be paying more in taxes, so overall it might not make much difference either way.

    • Scott says:

      You probably hit on something there.

      If home prices are higher for all and only a few get to take the deduction, property taxes are inflated too…FOR ALL.

  18. Todd says:

    Most people Do take this into consideration when purchasing a home. It is usually the first thing out of people’s mouths when talking about home ownership benefits.

    Personally, I would like to see this go away entirely. A home adds no value to society. It is a place to sleep and keep your stuff. The government really should not subsidize this industry any longer. I like the Canadian system where there is only interest deduction allowed for things that invest.

    Of course this would have to be phased in so that people who purchased can count on it for X many years while new purchasers do not need it. This will slow down the housing market…WHO CARES? Why should this one sector be supported by all Americans, even those who rent? It is time for certain parts of the economy to not depend on the government to be robust and profitable. Why not subsidize my purchase of caramels? Makes about as much sense.

    • zapeta says:

      Well said. I’d much rather have an investment tax break than a mortgage tax break. I think a gradual phase out makes sense.

    • TomM says:

      well said….and I love the idea of an incentive to invest. This would simply reward people for investing in the economy. However, you’ll probably hear the same old talk of “you’re giving tax breaks to only the rich”. When, in reality, your giving people incentive to become rich by investing.
      I own a home and like the interest deduction, and this was a factor in my decision to purchase a house instead of rent, but would be willing to phase it out over time if it were to be replaced with an idea like this.

    • uclalien says:

      The conventional argument is that home ownership adds stability to a community. I don’t fully buy that argument, but it seems intuitive on some levels. It’s akin to people having more skin in the game. But as a renter, I don’t want to see my city go in the dumps either.

      Interesting note on caramel:
      Sugar has been subsidized in the US for nearly 200 years. “Big Sugar,” as it’s known, consists of nine main sugar farms or refinery groups that have lobbied successfully for import restrictions and price controls in the US. To summarize, taxpayers subsidize domestic sugar production so we can pay higher prices on sugary goods.

      This has made the domestic production of sugary products, including caramel, very expensive. Here is more info on the negative side effects of these subsidies:

      1) From the Wall Street Journal (9/22/09), “According to a 2006 study by the U.S. International Trade Administration, each sugar job saved by propping up domestic producers costs three jobs in manufacturing, with many companies relocating to countries such as Canada and Mexico where the price of sugar can be one-half to two-thirds the rate in the U.S.”

      2) For this reason, sugar cane has been mostly replaced by corn syrup in many sugary goods, which is proven to be unhealthier (despite what the corn industry commercials say).

    • Grant says:

      I couldn’t have said it better myself Todd. I’m only a couple years out of college and haven’t owned a house yet but I don’t see why people who rent should be at any disadvantage compared to those who buy. Let the markets allocate capital to sectors that dictate this via simple supply and demand. I think the mantra of old that “Owning a home is part of the American dream” needs to be relinquished. The American dream has core fundamentals but a majority of its definition is just as dynamic as the changing world we are in. The tax code is complicated enough as it is and I don’t see the sense in providing benefits for any cause that isn’t clearly advantageous for society. I’d be interested to see what people’s thoughts are on the Child Tax Credit. I believe this is one initiative that is important for the longevity and prosperity of any country.

    • govenar says:

      Part of the problem might be the “too big to fail” type of thing; I don’t care if the housing market crashes, and it might be a good thing, if it doesn’t affect anything else; but since currently there’s so many people who bought at the high subsidized prices, letting them drop drastically would probably have large effects on other parts of the economy, indirectly affecting me even though I’m a renter.

  19. Blair says:

    As a renter who is potentially going to become a buyer in the next year or two, this is something I had failed to take into account. While I knew that the interest deduction would certainly increase our odds of getting a refund, it didn’t then occur to me that we could then purchase a more expensive home. Perhaps I’ll pretend I never read this post and avoid inflating our potential price range.

  20. Mike says:

    Who cares. The housing market is in the dumps. I’ll probably be able to buy a house pretty cheap right now.

    • uclalien says:

      My hunch is that, in real (and possibly nominal) terms, home values will continue to decline. So you belief that housing is “cheap right now” might not be accurate.

      Based on the most recent housing data, housing in going in the tank again. There is absolutely no reason to believe that the structural problems we have in our economy will be fixed anytime in the foreseeable future.

      The government keeps attempting to stop the inevitable via tax credits and other gimmicks. But when these gimmicks are removed, home values head south again.

    • uclalien says:

      Also, it depends how you define “cheap.” Currently, I can live in a much nicer rental at a fraction of the cost of owning here in CA, despite the fact that home values have dropped more than 50% in my area. And when you tack on property taxes, insurance, maintenance, some utilities, HOA/condo fees (if applicable), etc., owning is really expensive. If I then add on the flexibility that renting has on my ability to take a new job or promotion, renting blows owning out of the water.

  21. JB says:

    Would this effect rental properties or just primary/secondary houses?
    I would assume you could still use this on your rents/royalties form.

  22. Chuck says:

    The deduction should be phased out smoothly over the next 30 years. That should minimize the adverse impact on prices, and people who are currently relying on it.

    (Although the people relying on it are going to be in trouble anyway, because the interest is always decreasing anyway, so the effective payment is always going up.)

  23. Elloo says:

    If the deduction went away, I would no longer own but instead would rent a house. The current mortgage deduction funds the cost to own my home such as lawn care, snow plowing, annual a/c and furnace tune-ups, repairs, etc. I’d let the landlord pay those yearly costs with the added bonus of having the landlord spend his or her (and not my) valuable time to see to all of this stuff.

  24. Don C says:

    Maybe not everyone takes the mortgage interest (and property tax) deduction when figuring out how much mortgage you can afford, but there are certainly enough people out there that do. It will be enough to affect housing markets. Right or wrong, I bought more of a house because I knew the my annual tax liability will decrease.

  25. I think perhaps, had it never existed, the housing bubble would have been less severe. That sounds like kind of a terrible thing to say, but we all know how it goes when you’re counting money you don’t actually have yet – sense of proportion tends to go out the window.


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