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Clement Sialm
  Clemens Sialm
 

Paying Off Mortgage Early May Be the Wrong Choice

11/30/2006 --

Nearly 40 percent of households that prepay their mortgage would be better off investing the extra money in a tax-deferred retirement account.

ANN ARBOR, Mich.—Nearly four in 10 households that pay off their mortgage early are making a mistake, says a researcher at the University of Michigan's Stephen M. Ross School of Business.

At least 38 percent of U.S. households that currently "accelerate" their home mortgage, either by making extra payments or by taking out a mortgage for less than the standard 30 years, would be better off investing the extra money in tax-deferred retirement accounts, such as a 401(k) or 403(b).

"While it is not surprising that some households are not making the right choice, the magnitude of the overall inefficiency is striking," said Clemens Sialm, assistant professor of finance at the Ross School. "In particular, when faced with the trade-off between paying off an extra dollar of mortgage and saving that dollar in a tax-deferred retirement account, households often choose an inferior strategy leading to large aggregate losses."

Using data from the Federal Reserve System's Surveys of Consumer Finances, Sialm and colleagues Gene Amromin of the Federal Reserve Bank of Chicago and Jennifer Huang of the University of Texas at Austin investigate household choices between mortgage prepayments and retirement account contributions.

They found that households that make the wrong choice by prepaying their mortgage could gain 11-17 cents per dollar, on average, simply by redirecting these "misallocated savings" into tax-deferred accounts. This could save U.S. households as much as $1.5 billion annually—nearly $400 per household per year.

While there may be numerous reasons why households prepay their mortgage and decide not to contribute to retirement accounts—interest rate risks, liquidity and default risks, credit constraints, risk aversion and fixed costs of participation—it is difficult to rationalize this "inefficient behavior or forgoing the substantial tax benefit," the researchers say.

However, Sialm and colleagues say the reason may be simple—people just don't like debt.

"Empirically, debt aversion explains to some extent the household preference for reducing debt obligations in spite of incurring considerable monetary losses in the process," Sialm said. "Being motivated by a 'socially acceptable' savings goal like debt-free home ownership may eliminate other savings vehicles from the set of alternative investment choices.

"In all, the results indicate that many households do not take full advantage of the tax-qualified retirement savings opportunities. These households might relinquish substantial tax benefits and matching contributions of their employers. This fact is particularly puzzling as many of these households own substantial financial assets, which they could effectively transfer to their retirement accounts."

Read The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings.

For more information, contact:
Bernie DeGroat
Phone: (734) 936-1015 or 647-1847
E-mail: bernied@umich.edu