Why mortgage rates should be lower

More than $10 billion a year in U.S. taxpayer subsidies meant to assist house buyers may instead be adding to the profits of lenders, a new study finds.

The study concerns the mortgage interest deduction, America’s largest housing perk. Homeowners may deduct the cost of their mortgage interest from their taxable income each year, thereby trimming their tax bills.

Standard economics theory holds that consumer subsidies raise demand for goods, thereby shifting prices higher. With mortgages, the “price” is the interest rate. But with so many factors affecting interest rates over time, it’s difficult to tell how great a role the interest deduction plays.

Georgia State University professor Andrew Hanson devised a novel method: Focus on loans of around $1 million in size. Homeowners may deduct interest only on the first $1 million of loan value. If the mortgage interest deduction has no effect on mortgage rates, then mortgages for, say, $950,000 should carry the same interest rates as those for $1,050,000.

They don’t. Hanson looked at more than 900,000 loans made in 2004 and found that rates dropped as loan sizes crossed the $1 million mark, and that the larger the portion of the loan that was above this mark, the lower the rates went.

The study, published last month in Public Finance Review, an academic journal, controlled for a variety of factors, including location, income, race and the presence of a co-signer. It used only “jumbo” loans, defined in 2004 as ones for more than $333,700, in order to control for the typical rate difference between these and smaller loans.

Based on his findings, Hanson estimates that between 9% and 17% of the value of the mortgage interest deduction is captured by lenders in the form of higher interest rates rather than homeowners in the form of savings.

Although the mortgage interest deduction is a large source of tax savings for many mortgage holders, government accountants label it a “tax expenditure,” because the reduced tax revenue must be either made up with higher taxes elsewhere or added to the debt.

This year the deduction is projected to cost taxpayers $98 billion, or around $800 per household, according to the White House’s latest budget report. Through 2016, the cost is estimated at $609 billion, or just over $5,000 per household.

The study results suggest that between $55 billion and $104 billion of this cost through 2016, or between $466 and $881 per household, will go to lenders rather than homeowners.
Mortgage rates in the U.S. have hit record lows for six straight weeks, due to Federal Reserve efforts to reduce rates in order to stimulate the economy. On Friday, the average rate on a 30-year fixed mortgage fell to 3.67%, according to Freddie Mac.

But without the mortgage interest deduction, the rate would likely be closer to 3.3%, Hanson said.

The mortgage interest deduction is designed to encourage homeownership. But a 2010 study by researchers at the London School of Economics and Kansas State University found it to be an “ineffective policy” with “no discernible impact” on broad homeownership rates.

The Tax Foundation, a conservative think tank, says the deduction is a giveaway for those with high incomes and big houses, because they are more likely to itemize their deductions rather than claim the standard deduction on their tax returns. It also says the money flows disproportionately to high-tax and high-cost states; in 2008, the average mortgage interest deduction claimed by Californians was $18,876, versus $7,992 for Oklahomans.

The National Association of Realtors says repealing the mortgage interest deduction would amount to a tax increase, that first-time home buyers would be hurt the most and that house prices would fall further.

Jack Hough writes the By The Numbers column for SmartMoney.

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