Many households, at one time or another, face the trade-off between paying an extra dollar off the remaining mortgage on the house and saving that extra dollar in tax-qualified retirement accounts. In a world without frictions, paying off mortgage loans early and investing in retirement accounts would be equivalent saving decisions. In reality, however, taxes and transaction costs play a key role in the determination of the effective borrowing and lending rates. We show that, under certain conditions, it becomes a tax-arbitrage to reduce mortgage prepayments and to increase contributions to tax-deferred accounts (TDA).
Mortgage interest payments are deductible from taxable income for households that itemize their deductions, while investment income in retirement accounts remains effectively tax-exempt. Hence, households earn pre-tax returns (rL) in their retirement accounts and pay after-tax rates (1 ? ?)rB on their mortgage borrowing. Although the borrowing rate (rB) on the mortgage is likely higher than the investment rate (rL) in an asset with similar risk properties, we show that, as long as rL > (1??)rB, investors are generally better off saving in the TDA instead of prepaying their mortgage. Given the simplicity of this strategy, it is reasonable to ask whether and to what extent investors recognize this tradeoff in their personal decisions.
Using data from the three latest Surveys of Consumer Finances, we investigate house hold choices between mortgage prepayments and retirement account contributions. While it is not surprising that some households are not making the right choice, the magnitude of the overall inefficiency is striking. On the margin, 38% of households who prepay their mortgages could benefit from our proposed arbitrage strategy. 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. The finding that a significant number of households make substantial mistakes in their financial decisions is consistent with Campbell (2006).
To identify rational reasons for investors to forgo this substantial tax benefit, we consider the robustness of our proposed strategy to different assumptions. We show that interest rate risks, liquidity and default risks, and other potential constraints are unlikely to explain this inefficient behavior. Rather, investors seem to be influenced by an aversion to take on debt. Empirically, self-reported debt aversion and risk aversion variables explain to some extent the household preference for reducing their debt obligations in spite of incurring considerable monetary losses in the process. The propensity of debt-averse households to forgo tax arbitrage is related to the findings in Graham (2000), who shows that many corporations forgo substantial tax benefits by holding too little debt.
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The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings
