The mortgage interest deduction (MID) is a well-known tax incentive, the popularity of which arguably exceeds its efficacy. The typical rationale is that it promotes homeownership. It attempts to do this by making it easier for the taxpayer to increase his ability to borrow for the purchase of a home.
There are several problems here. First, it is generally claimed that elimination of the MID would cause a significant decline in home values. From the same fact, it is of course equally valid to say that the MID artificially inflates home values by a significant sum. Obviously, this inflation makes homeownership attainable, not more. Naturally, the National Association of Realtors is vocally opposed to any decrease in their commission, I mean, the deduction. For political cover, they claim that the middle class accrues the majority of the benefit, and that home sales drive the economy.
Now I am perfectly willing to admit that their argument has some merit. The deduction does make a real difference in the tax burden on mid-range income earners. Home construction and sales are absolutely fundamental to the health of the economy, constituting an estimated 15 percent of GDP. Because of this, it would be extremely imprudent to modify the MID under current economic conditions. But let us not pretend that the deduction increases homeownership in any morally relevant fashion.
The deduction is for the value of the interest on the mortgage. In theory, it allows a purchaser to take on a larger amount of debt than he could otherwise carry. (In practice, our present rock-bottom interest rates may be damping the effect of this benefit, at least for those who get approved for loans.) The deduction is simply useless to anyone who is not borrowing enough for the interest to exceed his standard deduction.
Using an online calculator, I estimated that a married couple, filing jointly, with a $290,000, 30-year mortgage in Pittsburgh at current market APR of 4.25 percent, in the 25 percent federal tax bracket (income up to $83,600) and paying $5,000 in property taxes, would only reduce their taxable income each year by about $2500 from deductions attributable directly to the mortgage interest. At 25 percent, this lowers their tax burden by $625 for interest, with another $1,250 taken off for property taxes. The savings total $1,875, which does not even cancel out the $5,000 of property taxes they would not be paying if they rented instead.
In other words, the decision to itemize is driven as much by state tax rates, healthcare expenses, and charitable contributions as it is by mortgage interest. Virtually nobody of modest income is going to decide to buy a house because of this meager benefit. He might buy a bigger, more expensive house than he would otherwise, but the decision to buy at all hinges on non-tax reasons. I suspect the realtors are aware of this.
What are these non-tax reasons? They are diverse, from the desire to live near a good school, to the desire for freedom to make changes to a property without incurring a landlord’s wrath. Yet there is another financial reason which is tangentially related to interest deduction. A mortgage is still among the most powerful financial instruments available to the middle class for leveraging its wealth. A bank would be crazy to lend a young couple $200,000 to buy stocks on margin. But back that loan with a house for collateral, and you have a transaction that occurs thousands of times every day all over America. That interest deduction might help you squeeze a bit more leverage out of the bank, but the important thing is the mortgage itself. When home values are increasing, the deal is near foolproof. When they decline, the national economy reels.
Despite the downside risk, however, I refrain from condemning this leverage PER SE. Millions of Americans have benefitted enormously from its magnification of their investment capital. Our current problems arose from the vast pool of easy money which flocked to real estate after the dot-com bubble burst. All that money, chasing too few good credit risks, inevitably led to an erosion of lending standards. This inflow of money, aided by the obscenely optimistic valuations of mortgage-backed securities, led to an unsustainable expansion of leverage unprecedented in human history.
Time will eventually repair the damage done, and regulations will no doubt be instituted in an attempt to avoid a repeat of such disastrous lending. For us, the housing question comes down to three concerns: (1) maintaining a manageable amount of leverage that fuels economic growth, (2) developing a housing policy that acts in accordance with subsidiarity in order to avoid the catastrophic degree of correlation to which our secondary markets are susceptible, and (3) creating beautiful, livable housing at all price points and levels of income. These latter two points will be the subject of my next column.
Matthew Balkey is a 5th-year architecture student. He would like to congratulate the one percent of readers who actually made it to the end of this article without falling asleep, and invites them to e-mail him at email@example.com.