December 22, 2006

Mortgage Tax Deduction

Who else thinks the mortgage tax deduction is a really bad idea?

I am buying a new house, and so I have been thinking about home prices, interest rates, and taxes. And as I listen to the "advice" I get from mortgage brokers, I get that slimy car-dealership feeling that everybody is trying to sell me something that I can't afford.

Several people have told me, "why not borrow money against your house to take the tax deduction? You can get a nicer house that way. And if you don't need the money, plow it into the stock market to make even more!" And it's not just the salesmen. Even conservative white-shoe investment advisors will agree that the mortgage tax deduction is a good enough tax break that we should considering borrowing against it beyond our real need for cash. (The current WSJ offers just this sort of advice.)

Does this sound nuts to you too?

Borrowing to Outbid Other Borrowers

So I am convinced that the mortgage tax break doesn't help anybody. There is a finite amount of real estate - the planet is not getting any bigger after all - so the only thing we get out of encouraging borrowing for houses is that we drive up the prices of houses for everybody. Ooh, I've a fat wallet because I got a great deal on a big loan - guess what? The other bidder got the same great deal, and so we are both just borrowing more to pay more.

To some extent, the high price of real estate encourages more investment in housing construction. But since the mortgage tax credit gives more money to rich people who can afford to borrow more, it really encourages investment in expensive real estate. The continuing housing boom in McMansions - actually, nowadays it's more like a boom in bona fide Mansions - is a luxury paid for by the American taxpayer.

And the McMansion boom is not making houses any cheaper.

Houses Really Are Pricey

Houses are too expensive. My elderly neighbor bought her house - she was its first owner - for about $20,000 in 1956 - and it was the most expensive house on the street. When I sell my smaller house - just as old, never renovated - I expect to get more than half a million for it. You might say that this is just inflation. Aren't higher prices just a reflection of a cheaper dollar and a wealthier nation?

No, the truth is that houses really are getting more expensive, any way you measure it.

Here is a graph of average U.S. housing prices. Adjusted for inflation, houses are actually about twice as expensive as 30 years ago. And home prices are not just that following the rise in real wages either (annual average wages can be found here). While in 1976, people averaged spending about 5 times their annual wages on a house, in 2006, houses are selling for more than 8 times annual wages. So yes, houses really are more expensive than they were when we were kids, no matter how you look at it.

We are making more money than our parents on average. But we have to save up more years of wages to afford a house even so.

A Debt Society Built on a Real Estate Bubble

We are not really waiting and saving and counting pennies for more years before buying a house, are we? Politicians and pundits like to point out that America has become a whole country of borrowers: they decry the federal budget deficit and talk about the evils of credit cards.

And yet it seems clear that credit cards are not the bogeyman. If you look at the Fed's data on household debt or other analyses of household debt, you will see that our borrowing habits have been mostly the same over the years, even in this era of credit card "innovation." There is one kind of borrowing that has been getting markedly worse: mortgage debt. In 1976, mortgage debt averaged about 40% of a year of income; in 2006 mortgages are larger than the nation's annual income.

We are indeed a nation of borrowers that continues to borrow more. Why are we borrowing money? To bid against each other for a finite stock of real estate, pushing the cost of housing to the highest levels in history.

Instead of paying what we think it's worth for real estate, we pay based on what we think other people are willing to pay. This is the essence of a classic Ponzi scheme, an investment pyramid, a bubble. The bidding is pushed higher by an army of bankers whose job is to encourage us all to borrow more. And it is a phenomenon that is supported and justified by the federal discount on cash for residential mortgages.

But the tax break doesn't make us richer. It is a trap.

The Right Way to Subsidize Housing

Roger Lowenstein of the NYT has a nice article arguing that the mortgage tax deduction is a really bad idea. But, as others have observed (like Dan Gross in Slate), the mortgage deduction is something that is politically impossible to get rid of.

Maybe here is a way. The mortgage tax deduction costs about 70 billion dollars a year. Every year about one million new homes are sold.

Why not give homebuyers a once-in-a-lifetime direct subsidy of $50,000 towards a single house purchase? The savings from cutting the mortgage tax deduction could more than pay for more than one million subsidies every year, with a nice margin left over to account for changes in behavior. Instead of being tilted towards rich people shopping for mansions, the subsidy would be flat, generous, and equal for all home buyers.

This fair, flat, subsidy would be very different from today's rich-tilted subsidy. Since it would not be an open-ended discount on cash, it would not cause an endless spiral of speculation for expensive houses. In fact, eliminating the rich-mortgage-tax-credit would probably pop the real estate bubble and cause a collapse in the McMansion business. In exchange, it would stimulate a more sorely-needed boom in the construction of lower-priced housing.

This seems like a tradeoff, and yet I bet both trends would be welcome by home buyers at all income levels. People buying their first house wish there were more "starter homes" being built, and the mortgage deduction isn't actually making their house buying much easier. And people shopping for mansions, well - they are snobby and rich and they'd like their expensive houses to be an exclusive thing instead of a mass-production industry anyway. Rich people actually hate McMansions.

And reducing debt incentives might be a first step towards transforming ourselves from a nation of borrowers back into a nation of investment, risk-taking, and self-reliance. It might set us on a path of freedom from yoke of 30 years of debt payments to foreign holders of Fannie Mae bonds. It might increase the savings rate, stimulate economic growth, and cut the trade deficit.

Seems like a win all around, does it not?

Posted by David at December 22, 2006 04:49 PM

I don't think the one-time 50K plan is a good idea... Did you have some idea of how to limit it to one million people per year? It would set off a mini housing boom as everybody tried to take advantage of it, both people who thought the new law wouldn't last long and older folks who don't have much time left to get in on the deal... You'd probably also see various predatory "helpers" to assist the poor and elderly to buy houses they still couldn't afford even with the bonus cash.... and you still would have all the people who do better with the current deduction eager to vote you out of office. The real estate industry might like it, though, and they seem to be a key lobby supporting the current deduction.

If the goal is to support "ownership", one idea might be to change tax laws that apply to landlords to make it less attractive to rent housing to people. I don't know enough of the details here to have a specific idea, but whatever it is there will be team of lobbyists arguing against the change.

The idea from the 2005 advisory panel of replacing the deduction with a tax credit seems like a decent one; that would insure the benefit went to all homeowners rather than just the ones who itemize. I don't know if the panel recommended a refundable credit or not, but making it refundable would extend the benefit to people to people earning under $50,000/year who often have no income tax liability.

It's hard for the country to take painful steps to fix a problem that we'd rather not acknowledge in the first place....

Posted by: David Maymudes at December 22, 2006 10:59 PM

You're right of course - the 50K plan would have no hope of working in practice. But I think the size of the equivalent-subsidy amount highlights the size of the mortgage tax deduction problem.

I guess it is a self-fixing problem. Eventually the housing bubble will crash on its own. Mortgaged homeowners will default; political realities will block reposession on any scale; bondholders who rely on housing collateral will lose their shirts; then bankers will realize that mortgage rates have to rise to offset the overspending risk that is caused by the tax credit distortion. Stay away from those Fannie Mae bonds.

In the meantime we will buy our overpriced houses, and we will continue to fritter away our tax revenues to finance McMansions. I still hate buying an expensive house knowing that crash will eventually come.

Posted by: David at December 23, 2006 12:04 AM

Australia has the "First Home Owners Scheme" -

Basically you can only claim the grant once, and only if you haven't owned a house before, avoiding causing a boom over the whole sector.

Posted by: Anonymous at December 23, 2006 06:45 AM

David Maymudes emailed me pointing out that my 1-million homes per year figure seemed too low to him. He is so good at back-of-the-envelope estimations. And he is right. I got my figure off the census bureau's new home sales index:

The problem is that this omits sales of existing homes, which are more numerous. The place for the existing home figures is the National Association of Realtors Existing Home Sales Index:

The actual numbers: sales of new homes number almost exactly one million, and sales of existing homes stand at almost exactly 7 million. The total is 8 million homes sold every year.

If we distributed the morgage tax deduction to each of these home buyers, it would be about $9,500 per transaction. I find it interesting that this is about the same size as Australia's first home owner grant.

Posted by: David at December 23, 2006 07:12 AM

Yaron made a similar observation recently too Not only does this drive up the price of homes, but it also drives up the size of new homes

Please Dave, give up that software career, and run for public office.


Posted by: Roger at December 24, 2006 01:38 AM

Nice essay.

IIRC, Congress did make some noises about mortgage tax reform a couple years back. Some of the ideas were quite reasonable (e.g., gradually lower the $1 million deductibility ceiling) yet they went nowhere.

Your 50k plan is interesting leaves the vast majority of homeowners out in the cold. 50k only for those who happen to be shopping at the time? Seems problematic both in terms of fairness and implementability.

The real estate industry would love it, though - just think of the buying frenzy it would generate. :D

Posted by: pcal at January 3, 2007 02:26 PM

Even without a deduction, using a loan to purchase real property or anything else for that matter makes sense. It is called leveraging. The average 30 year mortgage rate is currently 6.2% and the annual inflation rate approximately 3%. Since a mortgage payment is in fixed dollar terms, each year your payment to the bank is eroded by inflation thereby costing the homeowner 3% less annually. This lowers the effective rate the homeowner pays. If a person paid cash for a house he would lose the opportunity cost of investing the money. A nice, dull 10 year Treasury currently yields 4.8% free of Federal tax. Or spend the money and contribute to our already blossoming economy.

Eliminating the deduction simply means our "wonderful" government gets to spend more of your hard earned money on entitlements and earmarks. How about Steve Forbes' idea of eliminating all deductions and instituting a 17% flat tax? Great idea by a great capitalist.

Posted by: Gary at January 24, 2007 05:42 PM

Sorry! Typo on last post. T-notes and other Federal obligations are free of state and local tax, not Federal tax.

Posted by: Gary at January 25, 2007 09:11 AM

Gary - what people seem to forget is that, in the words of my old Cornell classmate and finance-nut, "money is freedom." When you tie up your cash by buying something - or even worse, when you give away your future cash by borrowing - you may be getting some extra stuff, but you are losing your freedom.

Houses are costly to maintain. And expensive houses are more costly. As soon as you build a new house, the structure starts to age and depreciate, and if the house is in a good area, you will be socked with high taxes for the privilege of owning it. What other investment requires that you carry insurance against fire? The bare costs of home ownership swamp any "profit" you might expect to make. I hope your roof doesn't leak.

But what if house prices go up a lot? They do that sometimes. What if they go up enough to cover your costs?

What would you say to a cattle rancher who offered to loan you $100K to buy a three-decade supply your favorite hambugers, deeply discounted? I don't think the answer depends on whether your expected returns might be a couple percentage points higher or lower because of a discount on the burgers. And I don't think it depends on whether the price of Angus Beef skyrockets in a decade. The fact is, you will be stuck paying $6K a year to pay off the interest for eternity, regardless of whether or your culinary choice still seems like a boatload of fun at the end of your 30-year debt obligation. There is a reason we don't buy most things this way.

Bankers call it "risk;" really what we are trading away when we are taking a loan is our freedom.

Yes, you should borrow money to build a business, hire some people, go to school, chase a dream. Borrow to invest in your childrens' future, absolutely. Does buying a mansion on a jumbo loan fit that description? No, I don't think so. Living in an expensive house is luxury consumption, pure and simple. It shouldn't be confused with an investment.

Posted by: David at January 27, 2007 08:57 AM

I think the biggest thing is whether or not people need a McMansion's square footage to live. It's inefficient to have a huge home with cathedral ceilings. I shudder at the thought of those home heating bills. Crazy.

I think too many people are overbuying homes. Your first home isn't going to be your dream home. You work up to that. My first home is a tiny condo, but I find as a single person, it's sufficient. I don't really need more than what I have. Sure I fantasize about owning a bigger apartment, but in truth, it's just a place to store stuff. To paraphrase George Carlin, "My stuff is stuff, your stuff is sh*t, and houses are just a place to store our stuff."

A mortgage shouldn't kill a person. And borrowing against a house just for a stupid tax deduction makes no sense at all. You are paying money just to reduce your taxes? Your deduction does not offer a tax benefit never equal to the interest itself. That's just plain stupid. (Oh, yes, I have done this once to manage my finances, not really my deductions, so I do know of which I speak and I do not consider it one of my wisest tactical financial decisions, but a strategically necessary ones.)

Posted by: mapgirl at February 7, 2007 11:53 PM
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