Retirement Saving Versus Mortgage Paydowns

Many financial advisers suggest that homeowners...speed up their debt payments, either by paying down their 30-year mortgage early or by taking out shorter-term mortgages. But by examining a large subset of these homeowners, the authors find that nearly 4 in 10 (38 percent) of them would save money by ignoring the advice.

In their push to reduce their debt, many homeowners are missing a low-risk opportunity to increase their wealth. The reason? They're making extra payments on their mortgage - or taking out mortgages shorter than 30 years - rather than funneling that extra cash into tax-deferred retirement accounts. In The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings (NBER Working Paper No. 12502), authors Gene Amromin, Jennifer Huang, and Clemens Sialm find that the costs of using this approach can be significant.

Of course, to benefit from such a strategy - what the authors call a "tax arbitrage" - homeowners have to have a mortgage, the option to put more money into a tax-deferred retirement account, and a "get-out-of-debt" mentality. Indeed, many financial advisers suggest that homeowners who are in that position speed up their debt payments, either by paying down their 30-year mortgage early or by taking out shorter-term mortgages. But by examining a large subset of these homeowners, the authors find that nearly 4 in 10 (38 percent) of them would save money by ignoring the advice. Instead, they should redirect those extra mortgage payments into a tax-deferred retirement account (TDA) invested in fixed income securities.

"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," the authors write. "In the aggregate, correcting this inefficient behavior could save U.S. households as much as 1.5 billion dollars per year."

Why more households don't take advantage of the tax arbitrage remains something of a mystery. True, Americans often make costly financial mistakes. The paper cites other studies showing households putting money into taxable accounts when they'd be better off using tax-free instruments. But the breadth of the mismatch in this case can't be explained entirely by a set of rational decisions, the authors write. Instead, many homeowners may be so averse to debt that they prefer to pay down their mortgages early rather than to maximize their overall wealth.

This is the first time those options have been compared, the authors write. "To the best of our knowledge, this is the first paper to ... [consider] retirement contributions and mortgage payments as two alternative forms of household savings decisions."

To come up with their sample of homeowners, the authors analyze three years of household balance sheet data -- 1995, 1998, and 2001 - from the nationally representative Survey of Consumer Finances. Of the average 102.7 million households in each survey, they find that slightly less than half were eligible for an employer-sponsored TDA. Of those, slightly less than half had a fixed-rate mortgage. (The authors don't evaluate variable-rate loans, which would have complicated the analysis.) Of this group of 22.8 million households, about 10.5 million prepay their mortgages and either contribute to a TDA or, at least, have the ability to. It's from this group that the tax-arbitrage winners emerge.

Perhaps it's not surprising that those who can realize a tax-arbitrage profit (TAP) tend to have more wealth and to make more money than the average homeowner, since the strategy most benefits those in higher tax brackets. Here's how the TAP works.

Homeowners may pay a higher interest rate on their mortgage than they can get on a low-risk investment, but the real cost of borrowing is often lower because mortgage interest is tax-deductible. The higher the tax deduction on mortgage interest, the greater the possibility that an alternative investment may earn a better return. The authors look at two alternatives: Treasury bonds (considered super-safe because they're backed by the federal government) and mortgage-backed securities (which earn a higher return but still are considered low-risk).

Using the more conservative investment, Treasury bonds, some 2.5 million households could gain some $10 to $11 for every $100 they moved from mortgage prepayment to a TDA. Using more aggressive mortgage-backed securities, some 4 million households would realize a gain of some $17 per $100 switched into mortgage-backed securities. That amounts to an average TAP of $394 a year for mortgage-holders who hadn't contributed to a TDA before (and thus were eligible to make a substantial switch). Those who already contribute some money to a TDA would average a slightly smaller gain of $375 a year.

These numbers probably underestimate the gains, the authors say, in part because they do not observe the matches households can obtain from their employers when they contribute to a retirement account and because they assume conservative limits on how much people could contribute to a TDA. The authors also assume that households spend their windfall immediately rather than invest it in the TDA, which would boost returns.

Of course, there can be risks with this savings strategy. Interest rates on mortgage-backed securities can fall, squeezing the margin of profit. People may be forced to move at a time when interest rates are higher than their current mortgage. But the authors conclude that these risks are low. If interest rates fall, homeowners can always refinance the mortgage and lower their cost of borrowing. If interest rates rise and they also face relocation, they often can delay the move, minimizing the financial impact. Other risks - such as mortgage default or a liquidity crunch - are not likely to arise with a strategy that simply reallocates dollars that homeowners already have, they add.

So the money is there to be saved - some $1.5 billion - if homeowners can screen out the financial advice they often receive, overcome their aversion to debt, and tap the TAP that awaits many of them.

-- Laurent Belsie