US Congress Ways and Means Committee

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Written by Michael McAlary

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Service Area: Behavioural Analysis and Economics

Industry Sector: Government

 

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Chairmont Submission - Home Mortgage Interest Deduction

 

1. Executive Summary

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This document outlines an alternative solution to the current Home Mortgage Interest Deduction (HMID). The solution is to allow an interest tax deduction based on the PMT formula. It is called the Interest Amortization Solution (IAS).

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There are significant policy advantages with this solution. The key ones are:

• Deficit reduction - In the short to medium term IAS provides a mechanism to improve the US Government budget position (deficit). This is a key outcome

• Fiscal and monetary policy -- IAS provides a direct link and measurable correlation between monetary policy and fiscal policy. Specifically, the US Government and the Federal Reserve will be in a better position to understand the direct economic consequences of changes in monetary policy on the budget. Changes in interest rates (monetary policy) will follow directly through to the budget and forward estimates, as a rate increase/decrease will be reflected in future interest deduction tax claims. This is more measurable than the current HMID scheme that is arbitrary

• Budget forecasting - It will provide a better forecasting mechanism for US budgeting. Combining the direct linkage (see previous point) and based on borrower behavior the US Government using behavior modeling tools, e.g. Structured Path Equation Modeling (SPEM) will be able to better forecast the likely amounts of future interest tax deductions

• Progressive dilution - There is a progressive dilution of the tax break, i.e. IAS slowly reduces the welfare nature of interest as a deduction. It is recognized that there may need to be capital gains tax relief to offset

• Supports home ownership - The US Government believes and supports the notion that home ownership is good for individuals, helps build communities and is generally economically beneficial for the USA. The IAS is consistent with that philosophy

• Improved financial literacy - Namely, tax payers who previously may not have understood how their loan repayments are calculated and how the PMT formula works. If the IAS is adopted then borrowers will be educated through their mortgage broker, financial adviser, accountant, tax advisor and bank on how the new tax regime works. This has major long term benefits for the USA

• Pension inadequacy - IAS is a solution that is consistent with addressing the inadequate pension savings of individual Americans. The current HMID discourages borrowers from repaying their home loans so when a borrower comes to retire, if they have not paid off their loan they may need to sell their property to help fund their retirement. By progressively removing the interest tax deduction it will make Americans seek out alternative investment opportunities

• Helps borrowers when financially vulnerable - When someone buys property it is when they are generally most financially vulnerable. They are frequently at their maximum serviceability and loan to value ratio, so this is the time when they should receive assistance from the Federal Government. The IAS is a tax relief mechanism that will help home borrowers during those difficult early years

 

We thank the US Congress Ways and Means Committee for allowing us to make this submission.

 

2. Introduction

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The US Congress Ways and Means Committee as part of taxation reform is considering whether interest on all home loans should continue to be deductible. In this document we refer to this as the HMID.

This paper sets out our proposal which we have called the Interest Amortization Solution (IAS). We understand this solution has not been previously tabled.

 

3. Proposed Solutions

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Some of the proposed solutions currently being examined by the Ways and Means Committee are:

• Complete elimination of HMID: This involves the entire phase-out of the mortgage interest deduction without any homeownership subsidy to replace it

• Replacement with credit: Replacement of the deduction with a narrowly targeted, one-time credit for first home buyers only

• Tax credit: Reducing the tax percentage payable by a specified tax credit

• Reduction of current interest amount: Charge lower rate of interest per month, so lower amount of deduction for the government

• Second homes ineligible: No deduction available for second properties

 

The advantages and disadvantages of each have been well documented, notably the potential for an adverse impact on the mortgage and property market. We understand this is something that the US Government, business community and consumers wish to avoid given that these markets are only starting to recover from the effects of the Global Financial Crisis (GFC). It is generally recognized that a downturn in property prices impacts the entire economy because of the multiplier effect on other industry sectors.

This paper does not explore the merits of each proposed solution.

 

4. Interest Amortization Solution

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The IAS solution allows all owner occupier borrowers to claim a tax deduction for the interest paid according to the PMT formula. The PMT formula is a function that calculates the monthly payment for a loan according to an interest rate and lump sum amount over a defined period of time. It can be used for both fixed and variable rate loans.

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According to the PMT formula for principal and interest loans, a borrower pays more interest and less principal early in the life of the loan. As diagram 1 illustrates, in the later years the reverse occurs. Each subsequent loan payment will cover more principal and less interest, shown by the downward-sloping curve.

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Using the PMT formula, if a borrower meets all repayments on the due date, then the actual amount paid will equal the theoretical amounts that should be paid.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diagram 1: Interest Amortization Solution

 

Having outlined the principles of the solution we now consider the 2 different models that may be used. They are:

1. IAS – Theoretical Interest Paid Model (TIPM)

2. IAS - Actual Interest Paid Model (AIPM).

 

All things being equal, the TIPM and AIPM will produce the same result, however because of human behavior this is not necessarily the case. Notably, some consumers pay their home loans off early while others, due to different financial circumstances, may end up in arrears or defaulting on their home loan.

The IAS approach can also be applied to Home Equity/Line of Credit facilities, not just Principal and Interest loans.

 

5. IAS – Theoretical Interest Paid Model

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Using the PMT formula we have calculated the annual interest schedule for a 30 year $222,261 home loan at 4% interest rate. The details are contained in table 1 in Appendix 1.

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Based on these assumptions, under the IAS proposal the borrower would be entitled to a tax deduction of $8,819.20 in year 1 reducing to $ 271.65 in year 30. This example is then mapped and illustrated in diagram 2 below.

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The total interest that would be claimed as a tax deduction over the 30 year period would be $159,737.88. This assumes that the loan goes to maturity.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diagram 2: Theoretical Interest Paid Model

As diagram 2 shows, the interest component of the monthly repayment is reducing each month, while the principal component is increasing. This means that at the end of year 30 the loan is paid off.

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A potential issue is that the IAS may lead borrowers to continually refinance so as to maximize their tax deduction. There are a number of potential solutions that should be explored. These include:

• Watch and see if there is a fundamental change in the human behavior, if there is a marked increase in refinancing, then consider further action

• Align the tax deduction to the property purchase date, not the date of the loan re-finance. This would mean that regardless of the number of times someone refinances, their tax deduction is linked to the property purchase date. This will maintain the integrity of the IAS approach

 

It is assumed that the IAS applies to owner occupier home loan borrowers only. This paper has not explored or considered IAS in the context of investment property buyers.

 

6. IAS – Actual Interest Amount Paid Model

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The second model is AIPM. As identified above if a borrower is a good payer, then the AIPM and IAS will produce the same result.

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So what about borrowers who are in arrears/default or pay off their loans early?

Arrears/Defaults

If the AIPM were to be implemented then there would be a loophole that would need to be closed, i.e. borrowers that are in arrears/default would be entitled to a tax deduction on their default interest. This is inconsistent with the philosophy that defaulting customers should not be rewarded for their arrears/default, as it would be a disincentive for them to remedy their arrears.

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The solution would be to limit the deductibility to the theoretical amortization, i.e. TIPM for borrowers in arrears or defaulting.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diagram 3: Actual Interest Paid Model - Default

Diagram 3 illustrates a default scenario under the AIPM. The “blue” shaded area would be excluded from the interest tax deductibility.

Early Repayment

The opposite scenario to a defaulting customer is a borrower that pays off their home loan early. In this scenario if AIPM is adopted, then these home loan borrowers would be penalized for their “savings”. Penalizing a borrower for good behavior does not make sense and is not effective policy. Some solutions could include allowing the borrower to claim a tax deduction or credit:

• for the outstanding theoretical interest amount calculated using the Net Present Value (NPV) of the remaining term. So if the borrower pays off 5 years early, then they claim the NPV of the last 5 years of interest on a lump sum basis even though they have not incurred the interest cost. This would act as an incentive for borrowers to pay off early

• on the theoretical amount until the loan is repaid, i.e. apply the TIPM solution rather than the AIPM for those in front on their home loan. This means that even if the borrower is paying more off their home loan each month, they are still getting a tax deduction on a TIPM basis. The borrower does not lose a tax deduction that they would normally be entitled to if they had paid the loan as required. This may act as a further incentive to pay off early.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diagram 4: Actual Interest Model Early Payment

Diagram 4 illustrates the event in which a borrower pays off their mortgage before the loan maturity date. The “blue” shaded area represents the amount that a good borrower would be penalized if the AIPM solution was implemented without addressing this anomaly.

 

7. IAS with Cap and Credit

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The IAS may be structured to:

• Cap the maximum interest deduction by limiting the loan amount. Specifically, the maximum home loan amount where a deduction is available could be $1m. If a borrower has a home loan of $1.5million, then they would be entitled to an interest deduction according to the IAS on the $1m only. The borrower would not be entitled to a deduction on the $500,000

• Include a credit/tax rebate scheme and/or

• Apply a ratio to the PMT formula so that only a certain percentage, e.g. 80%, of the interest is tax deductible

There will be other ways of limiting the scope of IAS that have not been published here.

 

8. Transitional and Grandfathering

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The implementation of any new tax regime brings with it practical and operational matters to be solved. We recognize that the IAS will have similar issues to most of the other solutions being considered. Implementation matters include communicating to the community, banks and professionals, e.g. accountants, financial advisers. The finance industry and accounting professionals will in turn need to be trained so as to inform their clients. We have given some consideration to this and we believe that a Transitional and Grandfathering approach would be the best solution. Some suggestions are:

• Start date. US Congress could legislate a start date from which this new model is applied to all new loans

• Transitional arrangements for existing borrowers. Many Americans are at different stages in their “debt life cycle”, i.e. they may have had the home loan for 10 years, so implementing IAS from Year 10 would mean a significant loss in their tax deduction and may cause financial hardship. A rule or formula would need to be developed that fairly dealt with existing borrowers. This rule may compare a borrower’s “theoretical” starting position and their current deduction and given them a certain percentage where this rule would be phased out over a certain time period, e.g. 5 years

It is recognized that the above is not an exhaustive list.

 

9. IAS Advantages

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The advantages are categorized by stakeholder.

US Fiscal Position & Monetary Policy

• Deficit reduction. In the short to medium term IAS provides a mechanism to improve the US Government budget position (deficit). This is a key outcome

• Fiscal and monetary policy. IAS provides a direct link and measurable correlation between monetary policy and fiscal policy. Specifically, the US Government and the Federal Reserve will be in a better position to understand the direct economic consequences of changes in monetary policy on the budget. Changes in interest rates (monetary policy) will follow directly through to the budget and forward estimates, as a rate increase/decrease will be reflected in future interest deduction tax claims. This is more measurable than the current HMID scheme that is arbitrary

• Budget forecasting. It will provide a better forecasting mechanism for US budgeting. Based on borrower behavior the US Government will be able to forecast the likely amounts of future interest tax deductions. The current HMID is arbitrary and does not readily convert into impacts on the budget. Whereas, the IAS solution does and tools such as Structured Path Equation Modeling (SPEM) can be used that will significantly improve forecasting by understanding human behavior

• Progressive dilution. There is a progressive dilution of the tax break, i.e. IAS slowly reduces the welfare nature of interest as a deduction. It is recognized that there may need to be capital gains tax relief to offset

• Implementable. Implementation should be relatively simple, including any transitional arrangements

Community

• Supports home ownership. The US Government believes and supports the notion that home ownership is good for individuals, helps build communities and is generally economically beneficial for the USA. The IAS is consistent with that philosophy. Defined formula. IAS is a structured solution that is directly related to the loan size, and can be capped if required. It is not an arbitrary solution that is open to different interpretations and possible tax avoidance

• Improved financial literacy. Namely, tax payers who previously may not have understood how their loan repayments are calculated and how the PMT formula works. If the IAS is adopted then borrowers will be educated through their mortgage broker, financial adviser, accountant, tax advisor and bank on how the new tax regime works. This has major long term benefits for the USA

• Pension inadequacy. IAS is a solution that is consistent with addressing the inadequate pension savings of individual Americans. The current HMID discourages borrowers from repaying their home loans so when a borrower comes to retire, if they have not paid off their loan they may need to sell their property to help fund their retirement. By progressively removing the interest tax deduction it will make Americans seek out alternative investment opportunities

Borrower

• Incentive to ownership. IAS still provides an incentive for Americans to buy a property

• Helps borrowers when financial vulnerable. When someone buys property it is when they are generally most financially vulnerable. They are frequently at their maximum serviceability and loan to value ratio, so this is the time when they should receive assistance from the Federal Government. The IAS is a tax relief mechanism that will help home borrowers during those difficult early years

 

10. IAS Disadvantages

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The disadvantages need to be considered comparatively to the current HMID scheme and other proposed solutions. This analysis should include the impact on the Community and the US Fiscal Position and Forecasting. This should be the next step in further analyzing the IAS.

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There are some Borrower disadvantages that are outlined below.

Borrower

• Removal of a major tax deduction. In the long run borrowers will not receive the same level of tax advantages they receive with the current scheme

• Borrower behavior. It is unclear what type of borrower behavior may result. Notably, will borrowers continually re-finance so as to be able to claim the maximum tax deduction? As outlined in section 3 there are solutions to this that will need to be explored

 

11. Conclusion

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IAS provides the opportunity for the US Government to reset the fiscal framework. It also provides a mechanism that directly links fiscal and monetary policy, while continuing to incentivize consumers on home ownership which is beneficial to the community.

It is recommended that the following be undertaken:

1. A more detailed financial analysis

2. A borrower behavioral study, using tools like SPEM

3. A comparative analysis comparing the IAS to other solutions be undertaken

4. A more detailed analysis of IAS and possible use in budget forecasting, and

5. A study of the relationship between IAS, monetary policy and fiscal policy

We wish to thank the US Congress’s Ways and Means Committee for allowing us to make this submission.

 

12. Appendix 1: PMT Example

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PMT Model: According to the IAS, in the early years of a loan the interest component of the repayments are significantly greater than in the later years, i.e. there is a progressive amortization.

The Theoretical Interest Paid Model is shown in table 1 below and illustrated in diagram 2.

The assumptions used to calculate the interest amount are:

• Home loan amount of $222,261, i.e. the US national average home loan amount

• Home loan term of 30 years

• 4% interest rate

• The borrower will pay off their mortgage according to the theoretical amortization schedule of the loan amount, i.e. they do not pay the loan off early or fall behind schedule

This example shows that over the life of the home loan that the borrower will pay $159,737.88 in interest.

Table 1: PMT Example

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