Why We Should Eliminate the Mortgage Interest Deduction
If you own a home, you probably borrowed money from a lender to pay for it; in other words, you took out a mortgage. Just like pretty much every other type of loan, a mortgage comes with monthly interest payments: you repay the bank more than what you borrowed, for the privilege of using the bank’s money to purchase your house. Pretty simple stuff, right? Even after the 2008 housing crash, around 65 percent of Americans own the homes they live in (as opposed to renting), so most of us are at least somewhat familiar with the concept of a mortgage. What we might not understand, however, are the tax implications of mortgages.
Under the current federal tax code, homeowners may reduce their tax bill by deducting the interest payments made on their mortgage loans from their overall income. If you paid $5,000 in interest on your mortgage over a one-year period, you can subtract this amount from however much income you earned during the year. Thus, you pay taxes on a smaller amount of taxable income.
This is called the mortgage interest deduction, and its proponents, most notably trade groups like the National Association of Realtors, believe it is a good policy because it “facilitates homeownership.” In the United States, encouraging homeownership has often been seen as an important—and bipartisan—governmental policy. In 1995, President Bill Clinton argued that increased homeownership could stimulate the economy:
[quote]Homeownership encourages savings and investment. When a family buys a home, the ripple effect is enormous. It means new homeowner consumers. They need more durable goods, like washers and dryers, refrigerators and water heaters. And if more families could buy new homes or older homes, more hammers will be pounding, more saws will be buzzing. Homebuilders and home fixers will be put to work. When we boost the number of homeowners in our country, we strengthen our economy, create jobs, build up the middle class, and build better citizens.[/quote]
And, in a 2002 speech, President George W. Bush stated that homeownership improves neighborhoods:
[quote]Owning something is freedom . . . It’s part of a free society. And ownership of home helps bring stability to neighborhoods. You own your home in a neighborhood, you have more interest in how your neighborhood feels, looks, whether it’s safe or not. It brings pride to people, it’s a part of an asset-based society. It helps people build up their own individual portfolio, provides an opportunity, if need be, for a mom or a dad to leave something to their child. It’s . . . an important part of America.[/quote]
Academic research furthers the claim that homeownership benefits society as a whole. In 1999, economist Edward Glaeser of Harvard, working with Denise DiPasquale, then of the University of Chicago, found that homeownership is closely associated with a variety of indicators of more involved citizenship—homeowners know their neighbors’ names, and they vote more—and such involvement makes for a stronger community. So, if the federal government sees increased homeownership as a positive goal, then shouldn’t governmental policies promote higher rates of homeownership? Of course. Two recent studies, however—one in 2001, which examined the correlation between homeownership rates and the tax treatment of mortgage interest across ten nations, and a subsequent one in 2012 study that compared homeownership rates between various nations in North America, Europe, Australia, and Asia—discerned no clear relationship between the existence of a mortgage interest deduction and increased homeownership rates.
In addition to failing to increase rates of homeownership, the deduction has two major consequences: it raises interest rates on most mortgages, and it encourages excessive use of debt. For these reasons, thorough reforms of the mortgage interest deduction, which costs the U.S. Treasury about $80 billion a year, must be seriously considered. But before going deeper into the problems with the mortgage interest deduction, it may be helpful to understand its origins.
In 1894, under President Grover Cleveland, Congress passed the first federal income tax, which was subsequently struck down by the Supreme Court. As a response, the Sixteenth Amendment to the United States Constitution was ratified in 1913, which allowed Congress to impose taxes on income.
As a part of the original 1913 tax code, all types of interest payments were deductible from federal income tax bills. For example, suppose you owned a factory, and purchased some manufacturing equipment. If you paid for this equipment with a loan, you could deduct the interest payments from your tax bill, just as we can do with mortgage interest today. The same policy applied for the interest on any type of loan one might obtain, whatever its purpose.
Economists believe that this broad deduction on interest was intended to ease borrowing for business purposes. Congress saw encouraging business growth as an important objective, and so chose to make interest payments widely deductible. Homeownership, or consumer borrowing more broadly, was likely a minor, or nonexistent, consideration at the time. After all, unlike today, in the early part of the 20th century, most homeowners purchased their residences with cash or savings, rather than through the use of mortgage loans.
After World War II, veterans returned home and started families. This led to a sharp spike in home purchases, as the portion of owner-occupied homes (an important measure of homeownership rates) rose from 45 percent to 62 percent. By the mid-1950s, most homes purchases were mortgage-based. Simultaneously, credit markets expanded, and Americans started making use of credit for consumer purchases like automobiles, electronics equipment, and clothing.
After years of taxpayers invoking the 1913 tax code to deduct interest for the purchases of goods paid for with credit, Congress grew increasingly alarmed. The taxpayers’ habits could now put a major dent in the U.S. Treasury coffers, as more and more goods were purchased with credit for the specific purpose of using interest payments on credit to reduce one’s tax bill. With this concern in mind, Congress passed the landmark Tax Reform Act of 1986, part of which phased out interest deductions for non-mortgage household debt. Thus, interest on credit card and other types of consumer debt was no longer deductible.
[pullquote_right]By the mid-1950s, Americans had started using credit for automobiles, electronics equipment, clothing, and homes.[/pullquote_right]
Simultaneously, Congress increased the size of the mortgage interest deduction. Interest was now deductible on the first $1 million of mortgage debt, used for acquiring or making major improvements on a primary residence or a second home. Interest was also deductible on the first $100,000 of a home equity loan, which is based on the improvement in value of a home after purchase. Suppose, for instance, you purchase a home for $300,000, and several years later the home is worth $400,000. Now, you can obtain a home equity loan in the amount of $100,000—the value in your home’s appreciation, or equity—and deduct any interest paid on this loan. The home equity loan can be applied for any purpose you chose, from adding a new room to a house to purchasing a boat for recreational use to paying for a child’s education. In this regard, the deduction on home equity loans functions as a loophole to the 1986 reforms: taxpayers can obtain a home equity loan and use it for consumer purchases that would not otherwise be interest-deductible.
The mortgage interest deduction is subject to an important limitation: itemized deductions. Before speaking about the itemized deduction, it is important to understand its counterpart, the standard deduction. The standard deduction is one that all U.S. taxpayers can take advantage of, regardless of their income status, as it allows them to reduce their taxable income by a fixed amount. In 2012, an individual could claim up to $5,950 as a standard deduction, while a married couple enjoys a standard deduction of up to $11,900.
Itemized deductions, by contrast, are a list of specified items that one may deduct from one’s tax bill. These include taxes paid to state and local governments, as well as medical expenses, contributions to non-profit organizations, and mortgage interest payments. Since rational taxpayers seek to minimize their total tax burden, and because taxpayers must choose between using either the itemized deduction or standard deduction on a tax bill, they will utilize itemized deductions only if the total of all itemized deductions exceeds the amount of the standard deduction. If your itemized deductions total $8,000, which is greater than the standard deduction amount of $5,950 for individuals, itemizing deductions makes sense. If you have just $4,000 total of itemized deductions, then you utilize the standard deduction.
Because taxpayers with higher incomes are, on average, likely to have more deductible items in their tax bill, only 30 percent of taxpayers have incomes sufficiently large to justify itemizing deductions, and only 70 percent of these—i.e. 21.7 percent of all taxpayers—claim the mortgage interest deduction. And since over half of households claiming the deduction earn $100,000 per year or more, they accrue approximately 78 percent of the deduction’s total dollar benefits. Greater wealth means larger mortgages, and larger mortgage loans mean spending a larger total dollar amount on mortgage interest. Thus, these households end up enjoying the vast majority of the tax breaks provided by the mortgage interest deduction.
In the U.S., the average mortgage amount has never crossed $1 million—in the first three months of 2012, it was less than one-fourth of that, at about $235,000—yet recent studies by economists suggest that the mortgage interest deduction raises interest rates on mortgages under $1 million. Some of the most impactful research on this question has been conducted by Andrew Hanson, then of Georgia State University. In a 2011 piece in Public Finance Review, Hanson hypothesized that the interest rates on mortgages below $1 million would be larger than mortgages with a value above $1 million. To test this prediction, Hanson compared interest rates of every dollar borrowed above and below $1 million, controlling for factors such as geographic location, race, and the use of a mortgage co-signer. What he found was that the interest rates on loans above $1 million were 3.3 to 4.4 percent lower than for comparable amounts below $1 million.
Using this data, Hanson further calculated that, by charging higher interest rates on loans eligible for the mortgage interest deduction (below $1 million), mortgage lenders were capturing 9-17 percent of the governmental tax benefits of the mortgage interest deduction. Essentially, lenders were forcing borrowers to pay higher interest rates because they might enjoy the benefits of reducing their tax burden through the mortgage interest deduction.
Over 78 percent of American taxpayers do not utilize the mortgage interest deduction. Yet it raises their mortgage interest rates without providing any tax benefits. As Glaeser observes, the deduction “yields substantial benefits to people who are likely to own anyways, and does much less for the middle-income group that seems more likely to be in the margin between owning and renting.” If the deduction were significantly beneficial to those with higher incomes (as are many facets of tax policy, like capital gains taxes), but also facilitated homeownership for the less affluent, perhaps it would be more justifiable. Unfortunately, given that the deduction seems to have only made mortgages less costly for those who can already afford to purchase homes, and more expensive for everyone else, the deduction appears highly inefficient and poorly targeted.
The American consumer, like his or her counterparts in Spain and the United Kingdom, is one of the most heavily indebted in the world. American household debt, which is defined as the total outstanding debt that members of a household owe to lenders (made up mostly of mortgages, credit card debt, and student loan debt), amounts to around 87 percent of America’s GDP, one of the highest rates on the planet.
Policy makers have expressed concern that such high levels of household debt could be harmful to the health of the U.S. economy, and so have sought to understand how such debt might be reduced. In a 2011 speech to a group of bank leaders, Minneapolis Federal Reserve President Narayana Kocherlakota argued that federal tax policy was one reason for excessive mortgage debt. Kocherlakota noted that because of the mortgage interest deduction, a homeowner has a greater incentive to use debt, rather than savings, to purchase a home. After all, taxpayers don’t receive any tax benefits for the use of savings in purchasing a home. In order to limit the use of mortgage debt in buying homes, while still making it possible for people to buy houses, Kocherlakota suggested that lawmakers might consider reducing the size of the mortgage interest deduction, while offering a tax credit for down payments used to purchase homes. Through this approach, excessive use of mortgage debt might be curbed, while the use of savings for home purchases would be encouraged.
Kocherlakota’s argument that the mortgage interest deduction encourages excessive mortgage debt is backed by academic research. In analyzing how altering the mortgage interest deduction might affect federal tax revenues, James Poterba at MIT and Todd Sinai at the University of Pennsylvania Wharton School of Business have found that households will respond to the elimination of the mortgage interest deduction in part by increasingly tapping into their savings and borrowing smaller mortgages.
Poterba and Sinai also hypothesize that phasing out the mortgage interest deduction could have negative effects upon rates of homeownership, especially for younger home buyers, who in most cases haven’t yet had a chance to build up their savings. However, their study did not address Kocherlakota’s concept of offering tax benefits for the use of savings in home buying, which might reduce any negative effects of eliminating the mortgage interest deduction.
International observers have sounded the alarm on the excesses of consumer debt too, noting that the preferential tax status of mortgages can encourage excessive borrowing in home purchases. In a 2009 report, economists from the International Monetary Fund examined the effects of policies similar to the mortgage interest deduction, and noted that “taxation does create substantial distortions in a market of central macroeconomic importance.”
Given the numerous negative aspects of the mortgage interest deduction, what might be a more effective means of promoting homeownership? One approach calls for a tax credit for homeowners, regardless of income status. Such a policy would solve the challenge of only more affluent taxpayers benefitting from the mortgage interest deduction, since everyone who owns a home would be getting tax benefits from their homeownership. In 1999, Richard Green of USC and Kerry Vandell of UC Irvine found that replacing the mortgage interest deduction with a tax credit of $1,173 for all homeowners would actually raise overall homeownership rates by about three percent (and that homeownership rates would increase for those with under $40,000 in annual income, while decreasing for those above that threshold, thus making homeownership increasingly viable for the less affluent).
Another proposal, in 2005, from Adam Carasso, C. Eugene Steuerle, and Elizabeth Bell of the Urban Institute, argues for a refundable tax credit of 1.03 percent of a home’s value up to $100,000. Their estimates indicate that 50 percent of all households would enjoy a tax cut if this policy were implemented, and this would actually result in households in the lower end of the income bracket enjoying substantial tax reductions, and so finding homeownership more affordable.
Ultimately, the mortgage interest deduction is flawed. It increases housing costs through elevated interest rates, without actually improving homeownership rates. The deduction also promotes excessive accumulation of mortgage debt, and functions as a giveaway for those who are already likely to purchase homes. For these reasons, policymakers should devise sweeping reforms to the mortgage interest deduction in the near future.