If there is one, almost universal, point of agreement on drivers of the financial crisis, it is that our financial system simply had way too much leverage. Much of that discussion has focused on financial institutions, leading many to suggest increased capital standards, so that banks have more equity and less debt. Often lost in the mix is the excessive leverage on the part of home owners.
We know, for instance, that the number one predictor of mortgage default is whether the borrower has equity or not. And while that should lead us to debate appropriate downpayment requirements, at least when the government backs the mortgage, we should not forget that our tax code encourages excessive leverage on the part of home buyers. And there’s no bigger incentive to get a bigger mortgage than the mortgage interest deduction.
Some might say we can’t risk removing any props from the housing market. My friends at the National Association of Realtors, for instance, have in the past argued that full removal would decrease home prices by up to 15 percent. Such an estimate depends on the level of interest rates (the higher are mortgage rates, the higher the value of the deduction and the greater the impact on house prices). With the current low level of mortgage rates, the negative price impact should be around 5 percent.
Given the already close to 30% national decline in prices, a further 5% would be less noticeable now than at a time when prices start to rise again. In addition, a 5% decline would attract more buyers into the market. Housing is just like any other good – when there’s too much, the best way to clear the market, perhaps the only way, is to drop prices. Getting rid of the deduction would make housing all the more affordable. And given current low mortgage rates,there would be far less distortions to do so now. Of course, all of this should be done in a budget neutral manner, lowering marginal tax rates across the board, which would have its own benefits to the economy.