One of the more scrutinized parts of the House Republicans’ tax plan is the proposal to reduce the mortgage-interest deduction. Taxpayers can now deduct interest on mortgages of up to $1 million. The proposal would reduce the cap to $500,000.
A lot has already been written about the policy implications of such a move. It’s also worth asking, however, how it would change the financial case for owning a home. National Economic Council Director Gary Cohn told Bloomberg on Friday that the ability to deduct interest “is not what drives you to buy a house.” But it should.
Many Americans think that a home is a good investment, but the numbers don’t support it. The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index tracks the value of single-family housing. The index has returned 3.7 percent annually from February 1987 through August, the longest period for which returns are available.
That’s well below the returns from traditional investments. The S&P 500 returned 9.9 percent annually over the same time, including dividends, and the Bloomberg Barclays U.S. Aggregate Bond Index returned 6.3 percent. In fact, homes barely beat cash. One-month U.S. Treasury bills returned 3.2 percent.
Homes in the big cities haven’t fared much better. The S&P CoreLogic Case-Shiller 10-City Composite Home Price NSA Index includes high-priced markets such as New York City, San Francisco, Los Angeles, Washington and Boston. The index has returned 4.1 percent annually from February 1987 through August.
The housing industry is quick to point out that the financial rewards of buying a home are greater than the Case-Shiller indexes imply because of the use of leverage. Buyers typically put down a fraction of the home’s price and borrow the rest. That leverage magnifies the gains from rising home prices, assuming those gains exceed the mortgage interest rate.
Here’s how it works. Say you put down 20 percent and borrow the other 80 percent at a fixed rate of 3.9 percent, which according to Freddie Mac is now the average 30-year fixed mortgage rate. Because the interest is deductible, the actual rate is far lower. I’m assuming a combined federal and state tax rate of 35 percent, which drops the after-tax mortgage rate to 2.5 percent, but the analysis is the same for any tax rate.
This is where the mortgage-interest deduction is critical. That lower rate magically transforms the 3.7 percent annual return from the Case-Shiller national home index into a return of 8.5 percent. For readers who want to do the math, the formula is 3.7% + [(80/20) x (3.7% – 2.5%)].
But if only half the mortgage interest is deductible, the annual return falls to 5.7 percent. And if none is deductible, the return is a measly 2.9 percent.
The mortgage-interest deduction would be even more important if mortgage rates were higher. According to Freddie Mac, the 30-year fixed mortgage rate has averaged 6.7 percent since February 1987. If mortgage rates were to rise to 6 percent, homeowners in the above example could expect an annual return of only 2.9 percent, assuming the interest is fully deductible.
If only half the interest is deductible, that return would turn into loss of 1.5 percent a year. And if none is deductible, that loss would widen to 5.5 percent.
And those returns don’t account for the myriad expenses that accompany homeownership, such as maintenance and real estate taxes, which further reduce the payoff from owning a home.
Given that the median home price in the U.S. is roughly $200,000, much of the discussion around the proposed $500,000 cap paints it as rich people’s problems. That isn’t entirely accurate. For one thing, middle-class Americans who live in big cities must often lean on mortgages that exceed the proposed cap to afford housing.
Also, the plan calls for doubling the standard deduction. If enacted, it would remove the need for most Americans to itemize deductions, including mortgage interest, which would effectively eliminate the deduction.
It’s too early to say whether the tax plan will go anywhere. But it’s a good opportunity to reflect on the effect of the mortgage-interest deduction. Without it, a home isn’t much of an investment. It’s just another expense of daily living.
Source: Bloomberg Gadfly, https://bloom.bg/2zwUYEq