On This PageWP 2006-05

The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings
Last Updated: 08/30/06
We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contri- butions to tax-deferred accounts (TDA). Using data from the Survey of Consumer Finances, we show that about 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean bene¯t of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these mis-allocated savings are costing U.S. house- holds as much as 1.5 billion dollars per year. Finally, we show empirically that this ine±cient behavior is unlikely to be driven by liquidity considerations and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.