Don’t Bank on the Mortgage Interest Deduction

Every conversation that I have had discussing the benefits of buying versus renting has eventually turned to the Mortgage Interest Deduction.

(What? Doesn’t everyone have those conversations? Just me?)

If you itemize deductions on your tax return, the Mortgage Interest Deduction allows you to deduct the interest that you pay on your mortgage from your income. This ultimately lowers your taxes and, in turn, your cost of home ownership.

This perk is often mentioned to me as a key reason for buying a home rather than renting.

There are a number of reasons why I disagree with this approach, but today I want to explore one in particular.

The Mortgage Interest Deduction could be gone soon.

Broadening the Base

For many years, Republicans have said that their goal for tax reform is to broaden the base and lower rates. As someone that follows policy closely, I’ve heard that phrase so often that it is at risk for becoming meaningless. I sometimes wonder if the politicians even know what they mean.

“Broadening the base” means expanding the universe of dollars on which people pay taxes. In short: eliminating deductions. They would then lower the overall tax rates using the money that the government saves by eliminating those deductions.

This idea is generally popular. People love the idea of lowering taxes, and if you can do it by closing loopholes, then all the better. Until you come for the deductions that they use.

The problem is that you can’t make much money by closing loopholes and eliminating deductions until you start eliminating deductions that are widely used. 

And the largest deductions for individuals are all popular:

  1. Health Insurance
  2. Pensions and 401(k)s
  3. Mortgage Interest
  4. Charitable Donations
  5. State and Local taxes

Recent Attempts to Kill the Deduction

While it is tempting to think that nobody would dare try to eliminate these deductions, there have been attempts before.

A panel appointed by George W. Bush recommended eliminating the Mortgage Interest Deduction in its entirety in 2005.

Mitt Romney’s 2012 campaign, after being pressured to release specifics regarding his plan to lower rates by broadening the base, added a ceiling for itemized deductions, including the Mortgage Interest Deduction. This would have significantly shrunk the value of the deduction

Paul Ryan has previously endorsed plans to cut the Mortgage Interest Deduction in half.

Some policy wonks see plans like Romney’s and Ryan’s as ways to kill the Mortgage Interest Deduction one step at a time.

How Economists See It

Part of the reason this proposal won’t go away is that economists on both sides of the aisle agree that the Mortgage Interest Deduction isn’t a good use of taxpayer money.

First, it doesn’t actually improve home ownership rates. Instead, the deduction encourages Americans to take on more debt, while artificially increasing the cost of houses.

Buyers and sellers incorporate the effects of the Mortgage Interest Deduction into their calculations when determining the value of homes. In this way, the tax benefits have actually already been incorporated into home prices. The deduction isn’t saving you any money because you’re overpaying for the house in the first place.

In fact, the Federal Reserve has found that the deduction increases the cost of houses by more than the actual savings from the deduction.

Favoring the Wealthy

Next, the Mortgage Interest Deduction helps people the most the need help the least.

The tax code incentivizes home ownership through the Mortgage Interest Deduction and the Property Tax Deduction. Combined, those programs cost $90 billion per year.

These deductions only benefit people that itemize deductions on their tax returns. This means that the vast majority of the benefits go to the upper middle class and the wealthy.

The federal government provides housing assistance for the poor through a number of programs like Section 8 and public housing. These programs cost a total of $51 billion.

We spend over 75% more on subsidizing housing costs for the well-off than we do for the poor.

The New Plan

We should keep all of this in mind as Republicans pivot to tax reform this month.

We don’t know all of the details, and the plans are certainly likely to change, but we do have outlines for Trump’s preferred plan as well as a House Republican blueprint.

Both would functionally eliminate the Mortgage Interest Deduction for most people.

Instead of eliminating the Mortgage Interest Deduction directly, they drastically increase the standard deduction.

With such a high standard deduction, most people that currently itemize would switch to the standard deduction and would leave behind their deductions.

Under the higher standard deduction, it wouldn’t make sense to claim the Mortgage Interest Deduction unless you had a home loan balance of at least $608,000, according to data from Trulia.

Under this plan, one estimate suggests that only 5% of families would itemize. This means that in addition to losing the Mortgage Interest Deduction, people are also losing the Property Tax Deduction. The National Association of Realtors points out that this will “effectively nullify the current tax benefits of owning a home.”

The Property Tax Deduction, along with the State and Local Tax Deduction and many others, would be eliminated completely under the House Republican plan.

Why We Should Care

Why should we care? The deductions will die because we choose the standard deduction. We’ll be paying lower taxes anyway, so who cares if it is via standard deduction or itemized deductions?

Remember when I said that the Mortgage Interest Deduction artificially inflates housing prices?

Well, eliminating the deduction would bring prices back down to where they should be.

That’s great for the free market. The government takes its thumb off the scale and the market corrects itself.

It’s not so great if you bought a home at those artificially inflated prices.

Depending on who you talk to, economists are expecting housing prices to drop somewhere between 6.9% and 10%.

Plus, these predictions are based just on the monetary effects. People tend to panic when they see prices falling, which could easily lead to a much larger collapse of the housing market in the short term.

Going Forward

It is certainly possible that tax reform doesn’t get passed. Or that it passes in a very different manner and doesn’t touch on deductions at all.

But the idea of eliminating the Mortgage Interest Deduction continues to come back again and again, with more force each time. Republicans want to broaden the base and there’s no reason for Democrats to defend government spending that benefits the wealthy. It could be only a matter of time until the deduction dies.

Either way, be careful when making housing decisions. Don’t buy more house than you need. Don’t max out your budget

Don’t bank on the Mortgage Interest Deduction.

14 thoughts on “Don’t Bank on the Mortgage Interest Deduction”

  1. Great post. I always cringe a little when people say “but having the mortgage helps lower my taxes”. Ugh.

    Personally we don’t have a mortgage, so we don’t have a dog in this fight. I agree it isn’t the best use of taxpayer money so slightly lean toward doing away with it. Perhaps more people would accelerate the mortgage pay down if the deduction was removed.
    Brad – recently posted…This is How You Achieve Financial FreedomMy Profile

  2. (What? Doesn’t everyone have those conversations? Just me?)

    ^^Haha! I feel like this all the time. Not specifically about mortgage interest rates, but all of PF.

    Way to make me think! I wonder what the heck would happen if the market corrected. Is it too soon? Would faith in the housing sector ever be restored?

    I also thought this helped a greater amount of middle-income families, which is why I wasn’t a huge fan of cutting it, even though it doesn’t directly affect me. We need all the paths towards upward mobility that we can get. But I can see how a lot of families may not be able to take advantage of the deduction–something I overlooked as a renter without that personal life experience.

    I like The National Low Income Housing Coalition’s proposal. Refundable tax credits help the people who actually need the help, and cutting the max deduction in half makes sense–especially if we see massive tax cuts for the insanely rich in coming months. Done by Forty had a thought-provoking article on refundable tax credits for retirement savings after myRA was shut down.

    Will be mulling over this one for days. 🙂
    Femme Frugalilty recently posted…Free Things to Do in Dallas #FinCon17My Profile

    1. Finance nerds unite!

      Refundable credits could definitely do a lot of good. We could rework the interest deduction to give less help to the well-off and more to the poor. If Congress wanted to encourage home ownership among the poor, there are a number of plans that would be better targeted than the current system.

      I’ll have to check out that Done by Forty article. Thanks for the recommendation. And thanks for the comment!
      Matt recently posted…Not Making a Decision is Making a DecisionMy Profile

    1. I could just be a pessimist, but I wouldn’t factor the deduction into the cost of owning a home at this point. I think we’re better off assuming the deduction won’t last. I don’t want to lock myself into a 30-year mortgage while including the deduction in my calculations and then find myself over my head if it is taken away.

      Thanks for the comment, Jason!
      Matt recently posted…Not Making a Decision is Making a DecisionMy Profile

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