Will Eliminating the Mortgage Interest Deduction Slow the Rate of Foreclosures?

The fiscal cliff drama over the past few months has captured the attention of Americans concerned about our economy – specifically how our lives will be particularly impacted.

And while it now seems that we will not take a terrifying plunge off the cliff – thanks to a last-minute deal brokered in Congress at the end of the year – there are still issues and concerns as they relate to the housing market and foreclosures.

The fiscal cliff agreement mentioned one of these issues directly – and many in the market were relieved to find that this particular issue survived the round of cuts that helped make the agreement a possibility. Here, we’re talking about the mortgage interest deduction, one that was at one point firmly in the crosshairs of budget-cutting politicians on Capitol Hill.

It’s conventional wisdom that this provision is good for the housing market, and intuitively, that appears to be the case. But is it really? Could removing this particular deduction actually help the market by restricting foreclosures and controlling risky behavior?

Taking Another Look at Mortgage Interest Deductions

Right now – unless Congress changes its mind down the road like it has threatened to do for months now – you can deduct the interest paid each year on your mortgage from your taxes. For many homeowners, that’s nothing to sneeze at; at 4% interest, a $170,000 home generates roughly $6,500 in interest for the first year.

While it’s not a dollar-for-dollar tax credit, it does reduce your taxable income by $6,500, which is sizable. Experts in housing claim that the deduction helps homeowners purchase homes by making them more affordable, which is true (in a sense).

But, does this create a false sense of security – or more precisely, affordability- for prospective homebuyers?

No one would argue that the deduction is the deciding factor behind a decision to purchase a home. But, the question is whether or not this deduction helps to create a perception in the mind of the buyer that a home that isn’t ordinarily affordable is more affordable than it really is.

Even beyond that, though, is the argument that the mortgage deduction doesn’t really offer much benefit to lower and middle-class homeowners – and instead harms the housing market by helping to artificially inflate housing prices.

Potential Impact on Foreclosures

One of the leading causes of foreclosures over the past six to seven years has been the inability for a homeowner to pay his or her mortgage because the homeowner paid more than the home was truly worth (due to inflated housing prices). When housing prices collapsed due to the demise of the housing bubble in 2007, many of these homeowners fell into foreclosure that could’ve possibly been avoided if they had scaled back their buying ambitions.

In theory, if the deduction were to be eliminated (or capped and reformed at the least), homeowners would have less of an incentive to purchase more home than they can really afford. That would in turn help curb defaults, which has the benefit of supporting home prices.

It is very likely that prices would decline in the aftermath of such an act, but would it really be that bad if prices returned quickly to realistic levels? After all, unrealistic expectations of future price performance, fueled by wildly-inflated home values, produced the worst housing market collapse in United States history.

Of course, the traditional arguments in favor of the deduction – support for affordable housing for lower and middle-class homeowners, economic production for the nation as a whole, and vital tax relief for groups of Americans who frankly need the help – are very powerful and persuasive.

Removing the mortgage interest deduction ultimately may not be a viable solution or one in the best interests of our country, and may not even be possible (since the political fallout from such a move would be virtual career suicide for politicians responsible).

But any proposed solution that can help the market and keep another crash at bay should be considered.  The housing market right now needs the mortgage interest deduction – but that doesn’t mean we shouldn’t talk about it.