The home mortgage interest deduction is heralded as a bastion for the middle class, an aid to the American dream. Proponents argue that it encourages home ownership. They worry without it the American housing market will crash.
People need their interest deductions in order to afford houses. It’s often cited as a reason to get out of renting faster. You may have even heard someone utter something along the lines of: Sure $1,000 of your $1,100 mortgage is going to interest and taxes, but don’t worry about it, its tax deductible!
It’s true; it is a tax deduction, but a worthless one. When tax proposals began to consider removing the home mortgage interest deduction people were up in arms about it. But they shouldn’t be, they shouldn’t care at all, and they certainly should not be making home buying decisions based on the deductibility of mortgage interest.
Mr. and Mrs. Example
To illustrate how worthless the home mortgage interest deduction is let’s take a look at an average couple, the Examples.
The Examples paid $200,000 to buy an average home in America. They have 10% equity, which means an outstanding loan balance of $180,000. They have a 30 year mortgage with a 5% interest rate.
The absolute maximum amount the Examples could pay in interest is $9,000 (outstanding balance times rate) so we’ll use that to illustrate our point.
The Examples also have some other very average tax numbers: $3,000 paid in property taxes, $1,700 in deductible sales taxes, and a 25% marginal tax rate.
Standard vs Itemized Deductions
We need to be clear on a couple things before we figure how little the Examples benefit from the mortgage interest deduction. When preparing their tax return every person has two general approaches to reducing taxable income, they can either take the standard deduction or itemized deductions. You can’t do both.
With very limited exceptions, everyone qualifies for the standard deduction. For a married couple filing jointly in 2017, the standard deduction is $12,700. It is named very appropriately, it’s standard, and everyone can use it.
Itemized deductions are also appropriately named; instead of taking the default standard deduction you can choose to take your deductions item by item. The major itemized deductions are home mortgage interest, property taxes, sales or state income taxes (not both), and charitable contributions.
Mortgage interest can reduce your taxable income only as an itemized deduction. The benefit of the mortgage interest deduction is thus only realized if your itemized deductions exceed your standard deduction. The value of the deduction is your marginal tax rate times the excess itemized deductions.
If a married couple’s itemized deductions equal $12,700 or less, then they count for nothing. This is true because you would get more benefit from the standard deduction and everyone, even non-home owners, qualify for that.
Ok let’s actually calculate the Examples benefit now.
The Current Calculation
The Examples itemized deductions are as follows: $9,000 in mortgage interest, $3,000 in property taxes, $1,700 in sales taxes, and $300 of charitable donations. Their total itemized deductions are thus $14,000. Hurrah for them, it’s more than the $12,700 standard deduction, which means they will itemize on their tax return.
The Examples itemized deductions are $1,300 greater than the standard deduction. Compared to a couple with the exact same income and no mortgage, the Examples will pay $325 less tax. This is the $1,300 excess deduction times their marginal tax rate of 25%.
That’s it. That’s the benefit they get from the mortgage interest deduction- $325. Not so life changing.
This is also the best case scenario. As the Examples own their home longer their payments will shift to more equity than interest. This means they’ll pay less and less mortgage interest every year and their tax benefit will be totally erased.
Would you buy a home based on being able to “save” $325? No way. You’ll pay 10x that much just in realtor commissions when you buy your house. So why do people act like the home mortgage interest deduction is a big deal?
The Proposed Calculation
Currently there is proposed tax legislation that would increase the standard deduction for married couples to $24,000. There is an important caveat in that it would do away with the personal exemption ($4,050 per person). As a practical matter then, the standard deduction is increased to $15,900.
A proposed feature of tax reform is to simplify the tax code by abolishing most itemized deductions, including the mortgage interest deduction. When people hear that their precious mortgage interest deduction may be going away they flip the freak out. The Examples, not understanding they were only saving $325 in tax, acted like this was an affront on the American dream of home ownership.
I guess they’re bad at math.
Under the proposed plan they’ll benefit more from the increased standard deduction than from keeping the mortgage interest deduction. The practical $15,900 standard deduction exceeds their $14,700 in itemized deductions.
What it Means
Even if the facts are slightly different, the dollars we’re talking about here are so small. Stop acting like the mortgage interest deduction is facilitating the home ownership dream. It saves you practically nothing. Any tax benefit that increases when you buy a more expensive house at a higher interest rate is terrible policy on the surface.
If we want to make home ownership a more affordable dream for more people we need to stop caring about the ineffective mortgage interest deduction. There are much bigger fish to fry.
Instead of falsely shouting that middle class couples like the Examples are getting screwed, let’s use the collective attention to educate people on the things that will actually help them afford a house. Teach people how to be smarter with their money. Educate people on how to live within their means so they can save for a home.
And please somebody shine a spotlight on the outrageous realtor profession taking 3-6% of home value every time a property changes hands. This special interest industry consists of not much more than expert networkers and appointment setters. They are the new taxi drivers, lobbying and legislating to keep progress at bay under the guise of consumer protection. It’s despicable.
Realtors snipe $6,000 of the Example’s home purchase, dwarfing the $325 benefit of a mortgage interest deduction. But for some reason realtors get a pass while people lament the potential loss of their misunderstood itemized deductions.
My point is this
If the crux of the matter is the slow death of the quintessential American dream: home ownership, then we need to move off the red herring that is the mortgage interest deduction. It does not have a meaningful impact for the vast majority of people.
Instead point your outraged fingers at the things actually causing home ownership to be an unattainable goal for many. Things like the steady rise in home prices, the egregious lack of knowledge and accountability for personal finances, misunderstandings of the true cost of owning a home, depressed incomes for the lower wage classes, the crushing student loan conundrum.
We need to shift our focus away from politicized points of rhetoric and on to matters of substance. You can do your part today – stop caring about the home mortgage interest deduction. It does not matter.
As always, buy a cheap house and drive small used cars.