The Mortgage Interest Tax Deduction (MITD) is one of the most destructive and unfair pieces of tax policy ever created.  It disproportionately hurts poor people and renters, and it is in large part responsible for the current financial crisis.  This tax policy must be repealed.

The tax deduction costs about $80 billion each year, and most of that money goes to the wealthiest homeowners with the most expensive houses.  Renters, and less wealthy homeowners who don't deduct (the majority of the US population) do not benefit at all, and effectively subsidize the shortfall.  This discredits the MITD's most popular justification as a policy that improves neighborhoods through homeownership, when the people who need it most see no benefit. In fact, the genesis of the MITD is more historical accident than social engineering.  Prior to 1984 all personal interest was tax-deductible, but when this policy was ended, the home deduction somehow survived.  It is now time to kill this one too.

Inflating the bubble

In addition to being unfair, it is also one of the direct contributors to the inflated housing price bubble that, when it burst, resulted in the Financial Crisis of 2008.  According to the National Association of Realtors,  the repeal of the MITD would result in a 15% decline in housing prices in some areas.  But this of course is the flip-side of the coin that the policy inflates housing prices by 15%.  Also, second homes are eligible for the deduction.  This inflated the housing bubble further over the last 10 years, as investors and speculators bought second homes with cheap money.  The government is essentially subsidizing housing market arbitrage.

MBS and CDO nightmare

The MITD makes longer term loans more desirable by reducing the effective interest rate.  Because of the deduction, one can borrow the same amount of money for the same overall cost, but for a longer time.

To better understand this, consider the relatively simple example of a multi-millionaire who is purchasing a $500,000 home.  He could pay for it in cash.  But why should he?  With the MITD he can borrow money for effectively below-market rates, and put it in higher yielding investments.  The tidy spread, perhaps 1 or 2 percent, compounded over 30 years, will make a nice profit.

Of course not everyone is a millionaire.  But even if you're not, the same dynamic holds true.  As long as you have excess income, you can save it in higher yielding investments instead of paying down the principal.

Unfortunately, long terms loans are much more volatile, first of all because the chance of default is greater (simply because there is more time in which to fail to make a payment), and secondly they are more sensitive to interest rate fluctuations.  This makes loans much more difficult to value.  Securities that were created by bundling up the loans - Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) - were the biggest problem in the 2008 financial crisis, in part because they were so difficult to value.  Some of them had gone to zero, but for others it wasn't known if they are worth only 10% or 50%. It will take 20 years to know the true value for some of these.  These types of financial instruments simply wouldn't exist without the MITD, because most home loans would be around 10 or 15 years.

Time to repeal

Certainly, the repeal of the policy would decrease housing prices.  Although painful in the short term, this is a good thing, because it creates more affordable housing for everyone.   However, it would significantly increase effective monthly mortgage payments for wealthier buyers.  These people would have to buy smaller houses.  There will be fewer mansions.

One of the biggest challenges in banking is a problem known as 'maturity mismatch': banks take short term deposits (money that can be withdrawn at any time) and lend it out for long-term loans.  A lot can happen in the life of the loan, and the risk of a liquidity problem is greater with longer term loans.  Shorter term loans (10 to 15 years) greatly reduce the maturity mismatch problem, and would improve the stability of the banking system.

In fact, maturity mismatch was the main cause of the S&L crisis in the 80's.  S&L's were originally limited by statute and regulation to fixed-rate home mortgage loans.  However, inflation in the mid-80's greatly reduced the value of the 30 year loans, making many banks insolvent.  In an attempt to fix the problem, banks were allowed to diversify into other short term real estate loans, but by then it was too late.

Repeal of the MITD will also greatly reduce the popularity of impossible-to-value toxic assets - MBS's and CDO's.  These things would never have been created in the first place without the MITD, and no one would miss them if they disappeared.  It is no coincidence that they are created only in the US - one of only a handful of countries that still permits the MITD.

Most economists, both conservative and liberal, agree that the MITD is bad policy.  Although it was challenged a few times in the past, currently there is no strong political desire to eliminate it.  However, given that it is bad for the majority of Americans, it should be possible to overcome the interest groups and lobbyists to create the momentum to kill it.

The MITD need not be repealed overnight.  The benefit can be reduced over a period of 10 years (for existing homeowners) to reduce the shock to the system, and can be coupled with an overall decrease in the tax rates for everyone.