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.
