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What if the mortgage interest deduction didn’t exist?

Welcome to the first edition of our What If? [3] 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 [4] 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 [5].

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?