WE'RE HEARING in the 23 years I’ve been following the mortgage finance industry, many proposals have been made to scale back or even eliminate the mortgage interest deduction.
These proposals have come from think tanks, commissions, economists and journalists. The motives were diverse: reducing the budget deficit, unraveling tax-related distortions on the economy, raising funds for public housing or offsetting reductions in tax rates. (A common refrain in the case against the deduction: Canada has no mortgage interest deduction but has a higher homeownership rate than the U.S.)
But all proposals to tamper with the mortgage interest deduction had one thing in common in the past: they were dead in the water. No Congress would tamper with such a cherished middle-class tax benefit. No president would want to alienate such a wide swath of the electorate.
This time the debate feels different.
While no one in Congress or the administration has proposed legislation to change the mortgage interest deduction—yet—the issue is clearly on the table as policymakers struggle to find ways to reduce the budget deficit and rein in spending. And the “sequester” scheduled to kick in on March 1 ups the pressure on Washington to do something to bring spending and tax revenue closer to alignment.
Congress has been under pressure to balance the books before. So why is one of the sacred cows of the tax code suddenly subject to slaughter?
Part of it is the way the debate over taxes is being framed. Republicans have locked arms and pledged that they are dead set against any further increase in tax rates. But the anti-tax wall begins to crack when you talk about “loopholes.” Both Republicans and Democrats have suggested that closing tax loopholes could be part of a deal to bring down the budget deficit. By the way, loopholes are usually just deductions by another name.
Despite all this, supporters of the mortgage interest deduction continue to have some pretty compelling economic arguments on their side, especially at a time when housing markets remain weak.
Michael Fratantoni, vice president of research and economics at the Mortgage Bankers Association, told me the most immediate impact of any reduction will be an across-the-board decrease in home values.
“The effect of the mortgage interest deduction is to reduce the after-tax cost of financing, so if that goes up, the question becomes to what extent is that lower financing cost capitalized into home prices.”
Academic studies on the issue have shown “a pretty consistent” estimate that any scaling back of the mortgage interest deduction would chop 5% to 15% off the value of homes, depending upon how big the reduction is and how it is structured.
When asked what impact that would have on mortgage loan performance, Fratantoni said it was “above my pay grade” to estimate how many more loans would default if values plunged by that much. But he noted that before the peak of the housing market in about 2005, a national decline in home values of 5% to 15% would have seemed unthinkable. And as the housing crisis demonstrated, a nationwide decline in home values can push defaults up dramatically.
Any change in the deduction would affect every homeowner because of the impact on home values, even if they do not use the deduction, he said. Now would be the wrong time to enact policies that could stymie the gradual recovery in the housing market.
Fratantoni said the impact on home values would be greatest in high-cost areas with high median incomes, especially on the East and West Coasts.
“That’s where you’d expect to see the largest hit to home prices if any change were made.”
He also disputes arguments that the deduction primarily benefits the wealthy. Economically, the impact would also have the greatest impact on households in the $100,000 to $200,000 annual income range, he said. The MBA says that about 91% of taxpayers who claim the mortgage interest deduction have incomes of less than $200,000 a year.
Already, tax changes that limit itemized deductions for high-income households will have the effect of limiting the mortgage interest deduction’s value for the wealthy, he said.
P.S. Last week, the MBA reported that the average rate on applications for 30-year, conforming FRMs had edged up to 3.75%, the “highest rate since September 2012.” Almost 20 years ago, in October of 1993, I got my first mortgage loan—at 6.62%—the lowest rate in a long time back then. I remember thinking, “We’ll never see rates this low again in my lifetime.” Good thing nobody ever hired me to manage interest rate risk.
Ted Cornwell has covered the mortgage markets since 1990. He is a former editor of both Mortgage Servicing News and Mortgage Technology.