The History and Possible Future of the Mortgage Interest Deduction

There has been a lot of discussion over the years about the mortgage interest deduction and its role in the housing market and personal income taxes. As with all things having to do with income taxes, everything is always subject to change or modification - and this is true with the home interest deduction. Lately, the issue has come up again, as the housing market is such an important part of the economy.

There exists the idea that the mortgage interest deduction was added to the U.S. Tax Code in an effort to encourage home ownership. It has done that, to some extent, although many homeowners do not feel its benefits, as only about 70 percent of homeowners take advantage of it due to itemized deductions.

A Bit of Interest History

All types of interest was tax deductible when the first national income tax was proposed in 1894, but the Supreme Court struck the income tax down. Following a constitutional amendment in 1913, the national income tax was enacted, and interest was once again an allowable tax deduction. In the same year, the Federal Reserve Act passed, leading the way for farm lending, but it was not until three years later that national banks were granted the ability to make direct loans on urban property.

After the income tax was passed and interest became deductible, most interest paid by taxpayers was related to farming or small businesses. There were no credit cards, and people mostly paid cash for goods and services, even for their homes. Despite some efforts to promote home ownership, the majority of city dwellers remained renters. In the early 1920s, the home ownership rate had risen to over 47 percent, but mortgage money was scarce and mortgages were structured very differently. They were also expensive, with interest rates as high as 25 percent, and terms from one to five years, with high down payments of at least 50 percent. In the 1930s, the U.S. government instituted the Federal Housing Administration (the FHA), insuring loans for 30 years. Fannie Mae (the Federal National Mortgage Association) was formed about the same time, and it revolutionized the lending industry. Still, in 1940, the ownership rate dropped to approximately 43 per cent. 

After WWII, however, when returning servicemen went to school on the GI Bill and bought homes under the VA loan program, the mortgage interest deduction became an additional reason for people to purchase homes. Housing and real estate development then became big business. It has remained so. What was good for housing was deemed good for the country. For the next 40 years, the home ownership rate remained relatively stable, despite major fluctuations in mortgage interest rates and steadily increasing home prices. The home ownership rate reached an all-time high of 68.9 percent in 2005. 

Over the intervening decades, credit card debt and financing plans have become a way of life. However, the interest deductions for credit card debt has been phased out. Home ownership, however, touted as the American Dream since the 1950s, steadily became a measure of success and an overriding goal for the majority of Americans, so the home interest deduction has remained in place.

According to the National Association of Realtors (NAR), "The housing boom that followed World War Two is one of the defining moments in America’s housing history." The NAR has been vocal in support of continuing the interest tax deduction over the years, and supports numerous other incentives to promote home ownership.

The Current Home Buying Picture

Home ownership rates across the country have dropped during the last decade coinciding with the housing market collapse, and reached the lowest point in nearly 50 years at the end of second quarter 2016, despite record low interest rates. Even though the third quarter rate is slightly higher, 63.5 percent, this drop has been viewed with alarm because it is seen as a measurement of housing industry health and citizen wealth.

Tax deduction supporters typically hold the opinion that tax advantages that stem from the mortgage interest deduction are a major factor for home buyers making the decision for home ownership vs. continuing to rent. Without the IRS-allowed mortgage interest deduction, it is argued, home ownership rates would fall and fewer people would be incentivized to buy a home. Supporters of the tax deduction also believe that the interest rate deduction builds communities through home ownership, strengthens the housing industry and provides jobs.

Itemizing to Save

Because not only interest, but also taxes, mortgage insurance, upfront points and fees associated with obtaining a mortgage are usually deductible, first-time homebuyers are likely to qualify under IRS rules to "itemize" deductions. This usually results in a tax savings over the standard deduction. In a way, it's a little like a forced savings plan. For a taxpayer in a 25-30% tax bracket, can amount to a substantial tax savings.

However, not every taxpayer can utilize the home interest deduction. Current limits on the interest deduction stand at a mortgage amount of $1 million for a couple or $500,000 for a single taxpayer. Because of the way mortgage interest is weighted early in the loan, referred to loan amortization, the value of the interest tax deduction is greater at the beginning of the loan and then decreases each year. Those who pay cash for a home, and those owners who pay off a mortgage receive no benefit.

Despite the talk of changes to the home interest deduction in the future, it exists today and will, more than likely, continue to be an important consideration in purchasing a home.