A $1.5 Billion Financial Planning Mistake?

New research indicates that 40% of homeowners may be making a serious mistake in how they allocate their extra cash. The standard advice -- pay down your mortgage -- might be wrong. It could be costing American homeowners $1.5 billion per year.

Far better, the authors say, to put the money into a tax-deferred retirement account; it could be worth up to 17¢ per dollar shifted to the "right" savings method.

In order to take advantage of this advice, you need

- a mortgage;
- extra money that you can allocate at your discretion;
- a tax-deferred retirement account such as a 401k, with room for additional contributions under the annual limit.

Someone in this situation faces a choice: should they take an extra (say) $1,000 and prepay their mortgage, or put it into a tax-deferred retirement account?

If they have a 7.5% mortgage and pay an effective 25% federal tax burden, their after-tax cost of borrowing $1,000 is $56 per year ($1,000 times after-tax interest rate of 5.6%). If the $1,000 is held in the tax-deferred account and used to buy (nearly) risk-free Treasury bonds or slightly riskier mortgage-backed securities, they'd earn about 1% more per year. That works out to $172 if you were to convert all the future savings into today's dollars.

The savings could be even greater. For instance, the authors assumed that people faced the same tax rate over time, when in fact they would probably be taxed at a lower rate when they used their tax-deferred retirement savings. That would increase the advantage of shifting money away from mortgage repayment and into a 401(k) or the like.

They also ignored any company match, a feature of many corporate 401(k)s. A match would also make shifting toward a 401(k) the better choice.

The authors think that the behavior can only be explained by homeowner's drive to pay down debt no matter the cost.

The study, "The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Saving," was written by Gene Amromin of the Chicago Federal Reserve, Jennifer Huang of the University of Texas, and Clemens Sialm of the University of Michigan. A complete copy is available as a pdf here.