Would losing the mortgage deduction make 15-year loans more attractive?

Posted by  on Dec 26, 2012

Q: With all the talk about eliminating the mortgage interest deduction, it made me wonder if that would make a 15-year mortgage more attractive because of its lower interest rate. What do you think?

A: Good point -- and the lower interest rate is just the start.

According to mortgage finance company Freddie Mac, as of mid-December, 30-year mortgage rates were at an average of 3.32 percent and 15-year rates were at 2.66 percent. Assuming mortgage interest is deductible, you can calculate the effective after-tax mortgage rate of each by multiplying those rates by your tax rate, and subtracting the result from the mortgage rate. You should find that the spread between 30-year and 15-year mortgage rates narrows when you calculate their respective after-tax rates.

Take away the deduction, and the after-tax rates are the same as the listed rates of 3.32 percent and 2.66 percent. In other words, the deduction narrows the spread between the two, and thus makes 30-year rates relatively more attractive.

This difference in interest rates is accentuated by the differing lengths of these mortgages, so to find the full extent of the impact that a mortgage interest deductionhas, you'll need to start with a mortgage calculator. Run two sample loans through a mortgage calculator, one assuming a 15-year loan and one assuming a 30-year loan. Most mortgage calculators will give you a breakout of total interest paid over the life of the loan. Calculate the difference in interest amounts (i.e., subtract the 15-year interest total from the 30-year total). Now, apply your tax rate to that differential.

The result of all this represents how much more you would lose on a 30-year loan than on a 15-year loan if the mortgage interest deduction were taken away. In other words, 15-year loans are always going to be cheaper in the long run, but a mortgage deduction does narrow the gap to some extent.

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