Indexfundfan\’s blog (new URL is Indextown.com)

April 19, 2006

Prepay mortgage or invest the money

Filed under: Finance — indexfundfan @ 10:03 am

Many investors juggle with mortgage payments as well as making regular contributions to their investment accounts. The question that sometimes come up is whether does it makes sense to prepay (i.e. make additional payments) the mortgage or invest the money.

Larry posted (49553) a paper that discusses the advantages and disadvantages of prepaying mortgage payments versus investing the money in tax-deferred accounts. Here’s the abstract:

We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts (TDA). Using data from the three latest Surveys of Consumer Finances, we show that more than 45% 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 tax benefit 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. households as much as 1.7 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity or other constraints, and that self-reported debt aversion and risk aversion variables explain to some extent the household preference for paying off their debt obligations early and hence their propensity to forgo our proposed tax arbitrage.

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