A ton has been written about the tax bill and it’s implications on the macro scale – it’s a tax cut for rich people at the expense of middle class, increases the deficit, etc.   I agree with most of these criticisms and overall am very concerned about what this bill does.

But I’ve been also thinking about it on a micro level.  I thought I share some thinking/math I’ve done on this front.   First the home mortgage deduction.   Lots of people think about this deduction simplistically.   Their accountant tells them that by taking out a big mortgage, they can save money on taxes!   So the run out and buy/borrow more house.

A doubly False Economy

People who borrow “to save on taxes” are being simplistic in two ways:

  • First, they aren’t saving money.   The government is subsidizing their interest, but they are paying more interest for the privilege of saving those taxes.   If you’re in the 35% tax rate, you’re saving $0.35 for every dollar you pay in interest.   You could achieve similar savings by simply burning piles of $100 bills in the backyard and taking the loss as a deduction, or losing a ton of money at the casino.   Of course, you get a bigger house or have more cash to play with, but don’t forget the bank owns the bigger house, and you are still paying interest.
  • The second way is more subtle.   The actual tax savings aren’t the full amount of interest, it’s the amount of interest minus the standard deduction.  This is because your alternative to borrowing isn’t taking no deduction, it’s just taking the standard deduction, which is $12,700 for a family.Let’s say you borrow $500k to buy your house, paying 4% interest, and you’re in the 28% tax bracket.   You feel great taking that big $20,000 interest deduction, yielding a big $5600 in tax savings (but again, by paying $20,000 in interest).   But that’s not what you saved by borrowing –  the alternative would be to take the $12,700 standard deduction and not borrowing, saving $3,556 in taxes.   So your return on borrowing is $2044.   The government is helping you pay for your interest, but not nearly as much as it appeared.  The breakeven point for this is $317k.   If you borrow less, you should just take the standard deduction and are getting no value from the interest deduction.

Eliminating the Home Mortgage Deduction, Nearly.

The new tax bill doubles the standard deduction to $24000, moving that breakeven point to a $600,000 loan.   This is true retroactively; a lot of you will now have lost the value of this deduction without even knowing it;  you’ll end up taking the standard deduction and the government is no longer subsidizing your loan.   And even if you have a $1M balance, a ton of the value of the deduction has been stripped away.

So what the tax bill does is “stealthily” eliminate the home mortgage deduction for all but a tiny number of  very wealthy Americans – and I think that’s great.   I’ve always hated what the home mortgage deduction does:

  • Encourages people to buy too much house.   I often have discouraging discussions with people who bought a huge house “to save on taxes”.   They would be far better off paying slightly more taxes and vastly less interest.
  • Encourages people to borrow more.   I also hear that people are putting almost nothing down on their house “to save on taxes”.   Again, they could also put more down and save much more in interest.
  • Encourages people to avoid paying down their loan balance and take out home equity lines of credit.   As you pay down your loan, your interest payments drop.   Oh no!   Better pay it slower or even better, take out a HLOC to buy a jet ski, to preserve the tax deduction!
  • Primarily benefits the rich, at the expense of the poor.   Note that the breakeven above was $317k in loan balance?   That’s more than most people in the country borrow, so few middle-class people were getting this benefit.

This all feels like a terrible policy to me.   Why is the government helping rich people to borrow more, pay it off more slowly, and own less of their house?

I had despaired of this ever being reversed, because the wealthy in this country would scream if anyone ever threatened to take it away.   This tax plan does it, but in a way that upper middle-class people won’t notice, at least until tax time when they realize this tax “cut” isn’t actually of much value to them because it sounds like it giveth, but in fact also taketh away.