The case against the mortgage interest deduction

A little over 10 years ago, I was flying back from London and had a long, long conversation with the man seated next to me. I had been to London to interview actor Jonathan Rhys Meyers for a now defunct Savannah-based magazine, and my neighbor had been there to pick up a cache of rare Emerson, Lake, & Palmer albums. Some interesting conversation ensued.

Somewhere along the line, the ELP fan went on an extended riff about how I should never pay off my house — I should just keep refinancing for long terms so that I could keep taking advantage of the mortgage interest deduction.

That wasn’t the first time that I was told not to pay down — or pay off — my mortgage. Lots of well-educated people, including several with accounting backgrounds, have told me about the benefits of the mortgage interest deduction.

For people like me who bought reasonably priced homes, such advice is utter nonsense. And no matter what the price paid for a home, the amount of interest being paid is always going to be higher than the tax benefit from the mortgage interest deduction.

I paid less than $80,000 for my house back in the mid-90s. A couple of years later, I refinanced to a 15-year mortgage and began paying extra principal every month — anywhere from $50 to several hundred, depending on my employment. Within a few years, my yearly interest payments were so low that it wasn’t even worth itemizing deductions. I paid off my house a couple of years ago. No, I don’t get the benefit of a mortgage interest deduction, but I have no house payment and own the asset free and clear.

We have a lot of elements in the tax code that promote preferred social behavior, and I think to a degree those elements are defensible.

And I think that it’s acceptable for tax policy to promote homeownership. (The homebuyer tax credit of recent years was a disaster — it just encouraged first-time buyers to buy homes before prices had bottomed out.)

Of course, the mortgage interest deduction doesn’t really promote homeownership. It promotes home purchases and the maintaining of high levels of debt on those homes. As a result, the deduction in effect subsidizes the real estate and banking industries as much or more than it helps mortgage holders.

From a great 2010 piece by the Tax Foundation:

Sound tax policy dictates that interest payments be deductible only when they are incurred to produce taxable income, such as those resulting from a small business loan. Mortgage interest on a principal residence doesn’t meet this requirement, but a special exception was carved out at the inception of the income tax in 1913, and the mortgage interest deduction has become one of the largest and most sacrosanct loopholes in the tax code.

For tax year 2008, a little over one quarter of the nation’s tax returns claimed the mortgage interest deduction, 26.8 percent of the nation’s 143 million tax returns. Rates of home ownership are much higher than this, but many home owners don’t claim the deduction. Often they live in low-cost homes for which the deduction isn’t large enough to make a tax difference, so they don’t itemize deductions on their tax returns. In addition, home owners who have paid off their mortgages make no interest payments to deduct.

The average tax return in the U.S. deducted $3,279 in mortgage interest; that includes all tax returns, even the non-homeowners and non-itemizers. Counting only the tax returns that deducted mortgage interest, the average amount was $12,221.

So in 2008, the average return that benefited from the mortgage interest deduction was from an individual or household paying on average $1,000 per month in mortgage interest. Is that a level of debt we want to reward and encourage with tax breaks?

If we want to encourage homeownership through the tax code, there are better ways to do it — ones that don’t encourage such high levels of debt.

Here’s a bit more background from the Tax Policy Center:

The MID was not originally placed in income tax law to subsidize home ownership. When the modern federal income tax was enacted in 1913 shortly after ratification of the 16th Amendment to the U.S. Constitution, all interest payments were made deductible on the grounds that interest payments
were an expense of earning business and investment income. Congress made no distinction, however, between interest incurred for the production of taxable income (such as interest on business loans) and interest incurred to generate non-taxable “imputed” returns from homes and consumer durables.

The deduction had little effect on housing investment before World War II because only the very highest-income individuals paid any income tax. The conversion of the income tax from a “class” to a “mass” tax during World War II, followed by a large postwar growth in home ownership rates fueled by the increased availability of long-term mortgage finance, converted the mortgage interest deduction from a provision used by only a few taxpayers into a major subsidy for middle- and upper-middle-income homeowners.