NEW YORK -- Homeowners have a lot at stake in the political showdown over the country's debt ceiling.
One of the major concerns to arise from the negotiations for many is the fate of a valued tax break. The benefit, which allows taxpayers to deduct their mortgage interest payments, is used by 35 million households.
Now lawmakers have proposed limiting the deduction as part of an agreement to raise the government's borrowing limit to avoid a default after the Aug. 2 deadline. But that's not the only concern for homeowners and prospective buyers as the negotiations heat up in Washington.
Even if lawmakers strike a deal by next week's deadline, there's still a chance that the government's credit rating could be downgraded. That raises the prospect of higher mortgage rates, meaning those who've been holding tight for home prices to fall further may feel that time is running out to take advantage of low rates.
Last week, the average rate on the 30-year fixed loan was 4.52 percent. That's only slightly above this year's low of 4.49 percent. But the rate could head higher if the government doesn't cut spending enough to hold on to its sterling AAA debt rating.
Whether you're a homeowner or thinking of buying, here's what you should know:
Q: What will happen to mortgage terms if the government defaults on its debt?
A: Some borrowers could find it more difficult to get approved for a mortgage. This might happen if banks become more cautious and slow their lending to each other, as they did during the height of the economic collapse in 2008, notes Greg McBride, a senior analyst with Bankrate.com, a publisher of financial data.
The government's cost of borrowing would also rise if there was an unprecedented downgrade of the country's credit rating. Those costs would be felt by all, because the interest rates on consumer loans, such as mortgages, are tied to government bonds.
"Any increase on Uncle Sam's borrowing would translate to higher costs for consumers," McBride said.
However, McBride notes that any uptick in interest rates could be partially offset by a drop in home prices. That's because the amount consumers are willing to pay for homes goes down when mortgage rates go up.
Q: If a default is avoided is there any reason mortgage rates would still rise?
A: Yes. Depending on the details of an agreement, ratings agencies could still decide to downgrade the government's debt.
Standard & Poor's President Deven Sharma on Wednesday refused to provide specifics on how much the government would need to cut spending to maintain its top-notch credit rating. But Sharma said some of the plans being floated by Congress could be enough to avoid a downgrade.
Moody's Investors Service has said the U.S. government would likely keep its top rating if it avoids a default.
In the case that the government cuts spending dramatically enough, mortgage interest rates could actually decline. That's because massive spending cuts would suggest that there will be a significant decline in overall economic activity, McBride of Bankrate.com notes. That in turn would push down interest rates.
Q: Just how much could mortgage rates spike if the government's credit is downgraded?
A: A downgrade shouldn't result in a sharp spike, since U.S. debt would still be one of the safest investments around, notes Jack Ablin, chief investment officer for Harris Private Bank.
"Investors already had the opportunity to move away from Treasurys, but the yields haven't done much," Ablin notes. "One good thing going for us is that there's a glut of savings and dearth of safe investments. How many AAA investment opportunities are really left?"
In the meantime, the anemic job market and struggling economy should keep low interest rates in check.
That doesn't mean there won't be any increase at all. Terry Belton, global head of fixed income strategy at JPMorgan Chase, estimates the government's borrowing costs would rise between 0.60 and 0.70 points if its credit rating was lowered. That would mean mortgage rates could rise to more than 5.1 percent.
Q: What about the tax break for mortgage interest payments? Wouldn't claiming the benefit negate the impact of any increase in rates for homeowners?
A: Only to a point. As it stands, homeowners can deduct the interest on mortgages of up to $1 million from their taxable income.
But exactly how much can save a homeowner depends on a few factors. As an example, let's assume you have a taxable income of $100,000 and are in the 25 percent tax bracket. That would mean you pay $25,000 in income taxes. If you deduct $10,000 in mortgage interest costs, however, your taxable income would drop to $90,000. That would lower your income tax to $22,500, meaning you'd save $2,500.
The break only benefits those whose itemized deductions add up to more than the standard deduction, notes Jina Etienne, director of tax for the American Institute of CPAs. Mortgage interest is usually the cost that puts filers over the line so they can itemize deductions.
Q: How could the mortgage interest deduction change under the current proposal in Washington?
A: A proposal put forth by a bipartisan group of senators -- known as the Gang of Six -- would lower the cap on eligible mortgages to $500,000. Second homes would no longer be eligible either. The idea is to restrict the use of tax breaks by wealthier households.
As the proposal stands, the change would apply to both new and existing mortgages, according to Jackie Perlman, a senior analyst for the Tax Institute at H&R Block.
It's not clear exactly how many homeowners would no longer be able to claim the tax break. But in June, only 2 percent of homes sold for $1 million or more and 10.5 percent sold for $500,000 or more, according to the National Association of Realtors.
Still, Perlman notes that there could be other changes to offset the impact for those who would lose the benefit.
"The idea of tax reform, regardless of party, is to try to make everything more simple and fair," she said. "So some people may lose benefits. But there's usually something in it for everyone, whether it's a lower tax rate or simpler form."
Q: Everything seems so up in the air. What are the chances this tax change could be adopted?
A: The current budget proposals being pushed by both parties envision bipartisan committees that would be charged with cutting spending. Such a committee would also have the option to include changes to the tax code. But that doesn't mean committee members would adopt the proposals put forth by the Gang of Six.
"(The Gang of Six proposal) was intended to form a model for an agreement," notes Mel Schwarz, director of tax legislation at Grant Thornton, an accounting firm. "It would be going too far to say it forms a blueprint."
Schwarz also notes that lawmakers would also be careful of adopting any changes that could impede the housing market's tenuous recovery.