The Pros and Cons of the Mortgage Interest Deduction

John W. Diamond, Ph.D.
Adjunct Professor of Economics at Rice University

Perhaps the most highly debated "benefit" to owning a home is the mortgage interest deduction. Deficit-fighting lawmakers contest that doing away with the deduction could save the country millions each year. Advocates say it's essential to promoting homeownership. Some say it only benefits the rich.

According to a recent survey from HSH.com, 55 percent of homeowners said the mortgage interest deduction was important. Interestingly enough, over 28 percent said they "weren't sure" if the deduction was an important financial incentive or not.

To learn more about the mortgage interest deduction and its place within the U.S. real estate market, we interviewed Dr. John Diamond, adjunct professor of economics at Rice University.

Q: There has been talk of doing away with the mortgage interest deduction. Could you discuss the pros and cons of this deduction?

A: The most common criticisms of the mortgage interest deduction (MID) are that:

  • It does not achieve its main goal of increasing homeownership
  • It is a tax break for the well-to-do

The MID is not structured properly to achieve the goal of increased homeownership for two reasons:

  1. The deduction is only allowed for those that itemize deductions (primarily higher income taxpayers)
  2. The value of the deduction increases with the individual's income tax rate so that higher income taxpayers receive more benefit than lower- and middle-income taxpayers

Thus, in its current state, the MID is more likely to encourage prospective homeowners to buy larger houses rather than to encourage significant homeownership at low- and middle-income levels.

Proponents of the MID argue that subsidizing homeownership is related to positive external benefits and thus homeownership should be subsidized.

Q: Do you think Congress should do away with this deduction, or perhaps alter it?

A: The deduction should be altered by reducing the cap on the amount of mortgage principal on which interest receives a tax preference, coupled with either:

  • Deductibility of only a fraction of home mortgage interest; or
  • A fixed-rate non-refundable tax credit for home mortgage interest

If deemed necessary to allow time for further recovery of the housing market, these provisions could be enacted with a delayed effective date.

Q: How would an altered MI deduction impact homebuying?

A: Dr. George Zodrow and I produced some simulation results on the effects of either eliminating or curtailing the MID (http://bakerinstitute.org/research/the-dynamic-effects-of-eliminating-or-curtailing-the-home-mortgage-interest-deduction).

The most dramatic reform was the complete elimination of the MID. When the MID was eliminated:

GDP: GDP decreases slightly in the short run due to the adjustment costs incurred in reallocating the capital stock, and increases slightly by 0.1 percent in the long run.

Investments: Overall investments increase by less than 1 percent, reflecting the expected reform-induced increases in investment in the non-housing sectors and the rental-housing sectors, coupled with a decrease in investment in the owner-occupied-housing sector of about 6 percent initially and 3 percent in the long run.

Asset values: Asset values increase in the non-housing sectors by less than 2 percent and by 3.5 percent in the rental-housing sector, coupled with a decline in the value of owner-occupied housing of roughly 4 percent.

Replacing the MID with a credit
The effect of replacing the MID with a 12 percent non-refundable credit subject to a $25,000 interest cap and limiting the MID to primary residences is qualitatively similar but significantly smaller. For example, for the capped credit, housing investment in the owner-occupied sector declines initially by 2.6 percent and by 1.5 percent in the long run, and the value of owner-occupied housing declines by roughly 2 percent.

This article The Pros and Cons of the Mortgage Interest Deduction originally appeared on HSH.com.

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