The Mortgage Professor: Adjusting the home mortgage to meet the retirement funds crisis:
the role of deductibility
Most economists are negative
afford them. This would result from
the much larger tax benefit on the
shorter-term mortgage.
For example, a $100,000 loan at
4.5 percent for 30 years has a monthly
payment of $506, of which only $131
is principal in month one. A loan of
$100,000 at 4 percent for 15 years has
a payment of $739, of which $406 is
principal. The deduction in month one
would be $275 larger on the 15-year
term, and the difference increases
over time. By month 60, the difference
has grown from $275 to $331, and by
month 120 it is $398.
Equally important is the swing in
the incentive to make extra payments.
The present system discourages prepayments
ElEctrical
Most economists are negative or ambivalent about the provision in the U.S. tax
code that allows homeowners to deduct mortgage interest from their taxable
income. The major concern is that the provision is regressive. Up to some limit,
the benefit increases with wealth. The wealthier the consumer, the more costly
the homes they buy, the larger the mortgages they take, the higher the interest
charge on the mortgage and the greater the deduction.
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or ambivalent about
the provision in the U.S.
tax code that allows
homeowners to deduct mortgage
interest from their taxable income.
The major concern is that the provision
is regressive. Up to some limit,
the benefit increases with wealth. The
wealthier the consumer, the more
costly the homes they buy, the larger
the mortgages they take, the higher
the interest charge on the mortgage
and the greater the deduction.
Some of this ambivalence is
reflected in the recently enacted Tax
Cuts and Jobs Act. While it did not
generate a lot of attention at the time,
that legislation reduced the maximum
mortgage amount on which interest
is deductible from $1.1 million to
$750,000. However, that legislation
did not adapt the deduction provision
to emerging new social priorities.
Change in priorities
A new priority is the amelioration
of the retirement funds crisis, as net
worth at retirement declines and life
expectancy rises. Since home equity
is a potential buffer against economic
hardship after retirement, the focus
of tax deductibility should shift from
increasing the affordability of home
ownership to inducing homeowners
to build equity more quickly.
One way to do that is to shift the
deductibility provision from interest
to principal. Such a shift would result
in faster equity growth, and could be
implemented in such a way that it did
not cost the government any more
than the current rule.
Shifting deductibility from interest
to principal would cause a swing
away from 30-year mortgages to
shorter terms by borrowers who can
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because they reduce future
deductions. The proposed system
would encourage prepayments because
they would generate deductions.
Rules of the game
To keep the costs down and
the incentives properly aligned, the
principal payments that are deductible
must be properly defined. They
consist of the principal component
of the recurring monthly payment,
and extra payments that reduce the
loan balance by the same amount.
They do not include repayments of
the loan balance on sale of the house,
since there is no reason to reward
house sales.
The eligible mortgage
is one that was
used to purchase the
house, or one that
refinanced the mortgage
that was used to
purchase the house.
A mortgage placed
on a house that does
not have a mortgage would not be
eligible. This prevents a homeowner
from taking out a mortgage in order
to pay it off immediately for a large
deduction.
Shifting the deduction from interest
to principal would probably cost
the government a little more because
principal payments usually exceed
interest payments. For example, on
a $100,000 mortgage for 30 years at
4.5 percent, principal payments add
to $100,000. Interest payments add
to $82, 407 if the loan runs to term,
$57,437 if it is paid off in 12 years. If
necessary, the cost of the new system
could be reduced by scaling down
the percentage of principal payments
that is deductible, from 100 percent to
a smaller figure as needed.
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