Abolishing the mortgage interest deduction would decrease the amount that homeowners would be able to pay for their homes by 17.65% and lower house prices by 19.94%, according to a new study recently accepted for publication in the Journal of Housing Economics.

The study by three Belgian economists found that the MID is one of the several reasons why income alone is insufficient to explain changing house prices even though price-to-income ratios are commonly used to measure imbalances in housing markets, especially as unsustainable house prices may raise concerns about financial stability.

“The metric (price-to-income ratio) does not incorporate the interest rate and therefore has ignored the effect of the decreasing long-term interest rates on house prices since the 1980s. Moreover, the maximum rate at which mortgage interest is deductible differs between countries and over time. This can lead to differences in the amount that households are able to pay that a simple price-to-income ratio ignores,” the wrote Sven Damen, Frank Vastmans and Erik Buyst, economists based at Center for Economic Studies, at KU Leuven, Belgium.

By taking a long term view of borrowers’ ability to pay that incorporates changes in interest rates as well as the value of the mortgage interest deduction, the authors compared eight nations with differing laws governing mortgage interest deductions.  They calculated how a 1 percent change and complete abolishment of the MID would affect borrowers’ ability to repay their mortgages.  They found that in the United States an increase in mortgage rates from 3.5 percent to 4.5 percent decreased borrowers’ ability to pay by 7.21% and decrease house prices by 8.61%.  Abolishing the mortgage interest deduction would reduce borrowers’ ability to pay for their homes by 17.65 percent and lower house prices by 19.94%.

“The effect is, however, larger in other countries where mortgage interest is deductible at higher tax rates or interest-only loans are more popular. If the Belgian government changes would have changed he tax rate at which households can deduct mortgage interest to zero in 2009, house prices would, ceteris paribus, decrease by 23.27%,” they said.

Among the eight nations in their analysis (Belgium Netherlands, United Kingdom, United State, Sweden, Norway, Finland and Denmark), the US ranked third regarding the impact of eliminating the mortgage interest deduction on borrowers’ ability to repay and house prices.  The impact would be greatest on borrowers in the Netherlands and Belgium.

“As unsustainable house prices may raise concerns about financial stability, it is important to understand the factors behind the evolution of house prices. An important element is that the budget constraint depends on mortgage characteristics and the MID.  An additional borrowing constraint and market clearing results in a relationship between house prices and a measure of the amount that households are able to pay,” they concluded.