Who Really Benefits from the Mortgage Interest Deduction?

by devteam June 27th, 2012 | Share

A recent article in Public Finance Review reports on a study of the impact of thernfederal mortgage interest deduction (MID) not on homebuyer behavior, but ratherrnon interest rates.  The study, conductedrnby Andrew Hanson of the Department of Economics, Georgia State University,rnfound that it may be mortgage lenders rather than homeowners who arernbenefitting from the perk.</p

Hanson says that the MID is the largestrnhousing-related subsidy in the federal budget. rnThe Office of Management and Budget estimates use of the deductionrnreduced income tax revenues by over $104 billion in the 2011 fiscal year and byrnover $437 billion between 2011 and 2015. rnElimination of the deduction is brought up on almost an annual basis byrnCongress and is strongly opposed by interest groups such as the MortgagernBankers Association and the National Association of Realtors®.</p

The author says that there have beenrnnumerous studies examining how the MID affects the user cost of housing, therndecision to own or rent, and the price of the housing stock.  These studies examine how changes in the taxrncode that alter the value of the MID will affect the demand for housing byrnlowering the net interest rate paid on debt-financed housing.  “A common assumption in these studies is thatrnthe gross interest rate (before the tax deduction) on a mortgage is independentrnof the subsidy created by the MID; this is equivalent to assuming that therneconomic incidence of the MID subsidy falls entirely on borrowers.”</p

Hanson, instead questions whether thernavailability of the MID affects the interest rate charged by lenders on homernpurchase loans and then uses the results to determine what portion of thernsubsidy is captured by lenders.  He saysrnthat knowing the economic incidence of the MID is important for a precise understandingrnof how the subsidy currently affects the housing market and how changing itrnwould affect the housing market in the future. rn”Models of housing costs in the existing literature do not account forrnMID-induced changes in the gross interest rate, and therefore may not preciselyrnmeasure the impact of the existing policy and could mistake the effect ofrnproposed policy changes.”</p

The federal tax code limits the MID to interestrnpaid on a mortgage used to purchase a home up to a balance of $1 million.  The author theorizes that, if lenders capturernsome of the subsidy created by the MID, then eliminating the subsidy onrnmarginal borrowing will reduce the gross interest rate charged by lenders forrnloans made above the limit.  He thereforerncompares the interest rate on marginal borrowing below that $1 million limitrnwhere all interest is deductible with the interest rate on marginal borrowingrnabove the limit where interest is no longer deductible.  He also tests the interest rate on loansrnwithin a smaller bandwidth around the MID limits. </p

Data used for the study is from FederalrnFinancial Institutions Examination Council (FFIEC) records on mortgagernoriginations for 2004, (commonly called Home Mortgage Disclosure Act (HMDA)rndata) which provides information on the purpose and characteristics of thernloans and the borrower including the rate spread at the time ofrnorigination.  Hanson used loans with arnrate spread larger than 3 percent because more data is collected on those loans.  This resulted in a population that differedrnin several respects from others in the HMDA base.  Loans are, on average, about $75,000 smaller,rnborrowers have about $20,000 less in annual income are less white and morernlikely to lack a cosigner than the full sample. rnHanson further limited his sample by selecting only those above thernconforming loan limit which at the time was $333,700</p

Hanson says that if the MID affects therninterest rate he would expect to see this change, not as a large one on thernentire loan right at the limit, but a more gradual change as the loan grows inrnexcess of the limit and he therefore uses a regression kink design (RKD) ratherrnthan the more common regression discontinuity design (RDD) which searches for arn”jump” that occurs at the MID limit rather than the difference in slope afterrnthe MID limit that RKD seeks.</p

To find the marginal interest rate,rnHanson took the difference between the amount of interest paid on a loan at thernlimit of $1 million with the amount paid on a loan $1,000 over the limit andrndivided by the marginal loan amount of $1,000. rn”This calculation reveals that the interest rate on marginal borrowingrnabove the limit is on average 3.7 percent lower and ranges between 3.3 and 4.4rnpercent lower than borrowing below the limit.</p

Depending on the assumed marginal taxrnrate and Treasury bond rate, the point estimates imply that lenders capturernbetween 9 and 17 percent of the subsidy created by the MID.  This has implications on how the subsidyrnimpacts the annual rental price of housing. rn</p

Under the standard user cost modelrnpresented by Hanson in his literature review, economists use costs such asrnproperty taxes, interest rate on the mortgage, maintenance and other factors torncalculate the rental price of housing, i.e. the user cost of owning arnhome.  Using this model for a $250,000rnhome, it is assumed that where the borrower is able to capture a full value ofrnthe deduction then the rental price is 6.5 percent of the purchase price.  If, on the other hand, lenders are able torncapture 25 percent of the subsidy in the form of higher interest rates then thernmodel shows the rental prices increase by 6 percent to 6.9 percent of thernpurchase price. </p

Hanson’s findings, however, indicaternthat at the high point of lender capture (17 percent) the standard cost modelrnunderestimates the rental prices by 3.92 percent and at the low point of thernestimate (9 percent) the model results in an underestimate of the annual rentalrnprice of housing by 2.07 percent.</p

Hanson said that while other studiesrnhave shown that the incidence of some housing subsidies is split between buyersrnand sellers, his findings are the first evidence that MID affects interestrnrates in the mortgage market and suggests that refinements to the user costrnmodel of housing are necessary to determine the impact of the MID on the annualrncost of home ownership and house prices. rn”The evidence presented here,” Hanson says, “suggests that suppliers mayrnpartially realize gains in the form of higher prices, rents, or mortgagerninterest rates from policies intended to make housing more affordable andrnincrease home ownership rates.” </p

An additional implication that might berndrawn from Hanson’s study is that eliminating the deduction would furtherrnpenalize existing homeowners who may already be paying a higher interest raternin exchange for that deduction. rnTherefore, if Congress is to eliminate the MID, a case could be made forrngrandfathering those homeowners until they sell or refinance their homes.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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