The Option Value of Mortgage Interest Tax Deductibility
43 Pages Posted: 3 Apr 2017
Date Written: March 30, 2017
The tax shield value of the mortgage interest deductibility (MID) can be significantly lower than what it might seem when the tax code requires the household to switch from ‘standard’ to ‘itemized’ deductions. We define the effective tax deductible rate (ETDR) for different households. Our pay-off model identifies convexities and concavities in the relationship between the effective mortgage interest tax deduction and a set of the underlying variables (i.e. household income, house price, and local and state tax rates). To quantify the expected value of the MID, a dynamic option-pricing model is proposed and solved. The model is simulated for a range of realistic household characteristics. Using the quantitative model we compare the relative attractiveness of an Adjustable Rate Mortgage (ARM) versus a Fixed Rate Mortgage (FRM), and demonstrate an inverse U-shape relation between the tax shield of the two types of mortgages and the household income. We find several inverseU relationships between the volatility of underlying variables and the present value of the MID. We then discuss the tenure and location choice implications of the model to analyze the impact of tax reforms on the ratio of rent to value for different classes of houses. Finally, we report a critical analysis of the MID representation in a set of popular real estate advising websites.
Keywords: Mortgage Interest, Tax Shield, Option Value, Housing Policies, Dynamic Valuation
JEL Classification: G21, R31
Suggested Citation: Suggested Citation