Mortgage Interest Deduction – Driving the Economy or Taking it for a Ride?

Anytime tax policy is targeted toward a specific segment of society such as homeowners, parents, investors, students or savers, there is bound to be discussion of the fairness of the tax policy. Who benefits? Who is penalized?

The mortgage interest deduction is no different. According to the National Association of Realtors, everyone benefits from this deduction. Its claim is that when tax benefits are removed from real estate ownership that the value declines. This sounds plausible, but by how much? NAR calculations indicate a 15% decline which translates into $20,000 to $30,000 reduction in equity to the typical homeowner. That sounds awfully high to me.

For 3rd quarter 2007 median single-family home price was around $220,000. If we assume a taxpayer financed a 100% to purchase a median home with a 30-year fixed mortgage at 7%, the monthly mortgage payment would be $1,464.

Let’s look at our example for a 30 year period. In the 360 months, total payments would be $526,921 of which $306,920 would be interest. For taxpayers in the 25% tax bracket this leads to tax savings of $76,730. So if the homeowner is effectively only paying $450,191 (526,921 less 76,730) over the life of the loan, how much home could be purchased if there was no deduction and $1,250 (450,191 divided by 360) is all that can be spent per month? At the same interest rate (7%) the home value would be $188,000. That’s a $32K difference which is very significant.

Remember though that the mortgage deduction doesn’t occur in a vacuum. Taxpayers can either take a standard deduction or itemize their deductions. If we only look at the ‘effective’ tax benefit (the amount that surpasses what would have been allowed using standard deductions), we see that only $53,079 of the interest provides a tax benefit. So at 25% that yields $13,270 in tax savings. Now the taxpayer is paying $513,651 (526,921 less 13,270) over the life of the loan. If $1,427 is now available on a monthly basis under the same assumptions, a $215,000 home could be purchased. That’s only a $5,000 (about 2.27%) difference in purchasing power which is a far cry from the 15% the realtors claim.

Am I advocating elimination of the mortgage interest deduction? Not necessarily. It is an idea which deserves some research and input from the real estate, mortgage and tax preparation industries as well as from consumer groups. But spending over $306,000 to save $13,270 in taxes makes this guy look like a genius.