Huang and Sialm Say Many Americans
Better Off Not Paying Down Mortgage Early
It is a fairly common scenario for homeowners across the United States. At one time or another they are presented with the opportunity to increase payments on their mortgages to pay down their debts faster. And many take it.
However, new research from Assistant Professors of Finance Jennifer Huang and Clemens Sialm of the McCombs School of Business and Gene Amromin of the Federal Reserve Bank of Chicago suggests that spending that extra money on paying off the mortgage is a mistake for many homeowners.
In their paper, “The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings,” the authors find that about 4 out of 10 homeowners would be doing better by their pocketbooks by funneling extra cash into a tax-deferred retirement account (TDA) instead.
“About 38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice,” the authors write.
The authors refer to the strategy of increasing TDA allocations as a “tax arbitrage.”
“In a world without frictions, paying off mortgage loans early and investing in retirement accounts would be equivalent saving decisions,” said the authors. “In reality, however, taxes and transaction costs play a key role in the determination of the effective borrowing and lending rates. Under certain conditions, it becomes a tax arbitrage to reduce mortgage prepayments and to increase contributions to tax-deferred accounts.”
And the amount of money that Americans are leaving on the table adds up in a hurry.
“While it is not surprising that some households are not making the right choice, the magnitude of the overall inefficiency is striking,” said the authors in the paper. “Depending on the choice of the investment asset in the TDA, the mean gain from such a reallocation ranges between 11 and 17 cents per dollar of misallocated savings. In the aggregate, correcting this inefficient behavior could save U.S. households as much as 1.5 billion dollars per year.”
Why don’t more homeowners take advantage of the tax arbitrage? Many homeowners may be so averse to debt that they prefer to pay down their mortgages early rather than to maximize their overall wealth.
“We term these households ‘responsible fools’ since they are motivated to reduce their debt obligations in spite of incurring considerable monetary losses in the process,” the authors write.
According to the authors, this is the first paper to examine retirement contributions and mortgage prepayments as two alternative forms of household savings.
