Monday, April 17, 2006

Responsible Fools? The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings by Jennifer Huang, Gene Amromin, Clemens Sialm

Have a few extra dollars? Debating whether to pay down your mortgage or invest a bit more in your retirement account? A working paper by Huang, Amromin, and Sialm suggests the latter may be a wiser choice.

SSRN-Responsible Fools? The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings by Jennifer Huang, Gene Amromin, Clemens Sialm:
"a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts (TDA). Using data from the three latest Surveys of Consumer Finances, we show that more than 45% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice."
Why would people pass up the tax savings? It may be that people have been so ingrained that debt is bad that they merely want to pay it down as soon as possible. In the authors'' words:
"self-reported debt aversion and risk aversion variables explain to some extent the household preference for paying off their debt obligations early at the expense of forgoing the tax arbitrage. 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."
Additionally, the auhtors point out that "[t]his propensity of debt-averse households to forgo this tax arbitrage is related to the findings in Graham (2000), who shows that many corporations forgo substantial tax benefits by holding too little debt."

The paper goes on to show that this is also consistent with the findings that people segment their accounts and do not consider retirement and housing accounts as substitutes.

Interesting paper.

Huang, Jennifer C., Amromin, Gene and Sialm, Clemens , "Responsible Fools? The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings" (March 15, 2006). Available at SSRN:


Anonymous said...

The extract cited is an either/or proposition.

Hoever, if one has maximized tax-deferred accounts for the year (including 401(k) and IRAs),applying prepayments to the mortgage makes sense as an extremely low-risk investment.

FinanceProfessor said...

I definitely agree..indeed, I have paid off mortgages in this day however, I am not sure if I did it because it was a low risk investment or because I just wanted to get the debt down. However, in either case my utility did go up ;) so it is not irrational :)



Matthew said...

Assuming your mortgage is accruing interest in the 4%-6% range, it makes sense to defer extra principal payments if you can generate a greater rate of return on those funds earmarked for early principal repayments. This should be easily doable with a reasonable equity portfolio and a 7+ year time window.

The effect is magnified by tax considerations: Long term capital gains are cut by a 15% tax, while your mortgage interest cuts your tax burden by a your average tax rate - probably closer to the 20%-30% range. In effect, the after-tax mortgage rate is reduced MORE than the after-tax investment rate of return.

That being said, I also pay down my mortgage aggressively because I value the peace of mind that comes with owning my own home. Not entirely logical, but hey, it works for me.

Matthew @ Crazy Money

KaptainMoney said...

You don't have to decide between when you can have both. You can do a combinaiton of both. You can use a bi-monthly mortgage payment plan and that won't increase your total monthly payments at all and it will still allow you to pay off your mortgage very quickly. Then the other money that you have and are trying to decide what to do with you can put in the tax savings.

Mortgage Note Buyer

Mortgage said...

I too definitely agree.. Indeed, I have compensated off mortgages in progress.
However, I am not convinced if I did it because it was a squat risk speculation or because I just required getting the debt down.