Who Really Benefits from the Mortgage Interest Deduction?

News

A recent article in Public Finance Review reports on a study of the impact of the
federal mortgage interest deduction (MID) not on homebuyer behavior, but rather
on interest rates.  The study, conducted
by Andrew Hanson of the Department of Economics, Georgia State University,
found that it may be mortgage lenders rather than homeowners who are
benefitting from the perk.

Hanson says that the MID is the largest
housing-related subsidy in the federal budget. 
The Office of Management and Budget estimates use of the deduction
reduced income tax revenues by over $104 billion in the 2011 fiscal year and by
over $437 billion between 2011 and 2015. 
Elimination of the deduction is brought up on almost an annual basis by
Congress and is strongly opposed by interest groups such as the Mortgage
Bankers Association and the National Association of Realtors®.

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

Hanson, instead questions whether the
availability of the MID affects the interest rate charged by lenders on home
purchase loans and then uses the results to determine what portion of the
subsidy is captured by lenders
.  He says
that knowing the economic incidence of the MID is important for a precise understanding
of how the subsidy currently affects the housing market and how changing it
would affect the housing market in the future. 
“Models of housing costs in the existing literature do not account for
MID-induced changes in the gross interest rate, and therefore may not precisely
measure the impact of the existing policy and could mistake the effect of
proposed policy changes.”

The federal tax code limits the MID to interest
paid on a mortgage used to purchase a home up to a balance of $1 million.  The author theorizes that, if lenders capture
some of the subsidy created by the MID, then eliminating the subsidy on
marginal borrowing will reduce the gross interest rate charged by lenders for
loans made above the limit.  He therefore
compares the interest rate on marginal borrowing below that $1 million limit
where all interest is deductible with the interest rate on marginal borrowing
above the limit where interest is no longer deductible.  He also tests the interest rate on loans
within a smaller bandwidth around the MID limits.

Data used for the study is from Federal
Financial Institutions Examination Council (FFIEC) records on mortgage
originations for 2004, (commonly called Home Mortgage Disclosure Act (HMDA)
data) which provides information on the purpose and characteristics of the
loans and the borrower including the rate spread at the time of
origination.  Hanson used loans with a
rate spread larger than 3 percent because more data is collected on those loans.  This resulted in a population that differed
in several respects from others in the HMDA base.  Loans are, on average, about $75,000 smaller,
borrowers have about $20,000 less in annual income are less white and more
likely to lack a cosigner than the full sample. 
Hanson further limited his sample by selecting only those above the
conforming loan limit which at the time was $333,700

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

To find the marginal interest rate,
Hanson took the difference between the amount of interest paid on a loan at the
limit of $1 million with the amount paid on a loan $1,000 over the limit and
divided by the marginal loan amount of $1,000. 
“This calculation reveals that the interest rate on marginal borrowing
above the limit is on average 3.7 percent lower and ranges between 3.3 and 4.4
percent lower than borrowing below the limit.

Depending on the assumed marginal tax
rate and Treasury bond rate, the point estimates imply that lenders capture
between 9 and 17 percent of the subsidy
created by the MID.  This has implications on how the subsidy
impacts the annual rental price of housing. 

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

Hanson’s findings, however, indicate
that at the high point of lender capture (17 percent) the standard cost model
underestimates the rental prices by 3.92 percent and at the low point of the
estimate (9 percent) the model results in an underestimate of the annual rental
price of housing by 2.07 percent.

Hanson said that while other studies
have shown that the incidence of some housing subsidies is split between buyers
and sellers, his findings are the first evidence that MID affects interest
rates
in the mortgage market and suggests that refinements to the user cost
model of housing are necessary to determine the impact of the MID on the annual
cost of home ownership and house prices. 
“The evidence presented here,” Hanson says, “suggests that suppliers may
partially realize gains in the form of higher prices, rents, or mortgage
interest rates
from policies intended to make housing more affordable and
increase home ownership rates.”

An additional implication that might be
drawn from Hanson’s study is that eliminating the deduction would further
penalize existing homeowners who may already be paying a higher interest rate
in exchange for that deduction. 
Therefore, if Congress is to eliminate the MID, a case could be made for
grandfathering those homeowners until they sell or refinance their homes.

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