Pay Off a Mortgage Early?

Not if you want to build wealth, new research suggests.

Jim Schenke has no car and student loan payments, and he and his wife avoid credit card debt studiously. Schenke also makes an extra payment each year toward his fixed-rate, 30-year mortgage, which has a rate of 6 percent.

But he doesn’t contribute to his employer’s 403(b) plan; Purdue sets aside $5,000 annually for his retirement.

“The only company I owe money to is my mortgage lender, and I’m going to be beholden to them for as short a time as I can be,” says Schenke.

But a new study suggests Schenke might be better off putting that extra cash into his employer’s retirement plan. Researchers found at least 4 in 10 homeowners would build more wealth by putting additional mortgage cash into tax-deferred retirement plans.

An estimated 23 million homes face the mortgage prepayments vs. retirement savings dilemma. Switching the money to retirement savings would save U.S. households up to $1.5 billion a year, they estimate.

“The study is about making optimal use of savings,” Gene Amromin, financial economist with the Federal Reserve Bank of Chicago, says. “If you were to move a dollar from here to there without increasing risk, would you come out ahead?”

Using data from the Federal Reserve, researchers examined individuals who had a fixed-rate mortgage with either a 15-year term or a 30-year term on which they made extra payments.

The people involved were eligible to participate in a tax-deferred account for retirement and weren’t maxing out contributions; and took advantage of the mortgage interest deduction by itemizing tax returns.

DO THE MATH

Consider a homeowner who takes out a 30-year fixed-rate home mortgage loan at 6 percent, and is in the 25 percent tax bracket; he effectively pays 4.5 percent on the mortgage.

“If you invest in Treasuries in your 401(k) plan that are earning 5 percent tax-free, that’s a risk-free way of increasing your return,” Amromin says.

Researchers examined household goals for making home mortgage payments early, and looked at what would happen if they invested the money in a retirement plan instead. For example, in the interest of making an apples-to-apples comparison, the researchers considered two investment scenarios:

SCENARIO A: The investor puts an extra amount toward his mortgage each year, paying off a 30-year fixed mortgage in 25 years.

SCENARIO B: The investor puts extra cash in his 401(k), investing it in Treasury bonds or mortgage-backed securities. After 25 years of paying the mortgage at a normal rate, the investor withdraws a lump sum from his 401(k) to pay off the house - incurring income taxes (along with a 10 percent penalty if the money is taken out before age 59.5).

Although mortgage rates, income taxes, and 401(k) contributions vary among households, in about 40 percent of the cases, putting the money into a retirement fund beat paying the mortgage off early.

“Basically, the investor met exactly the same goal of paying off the mortgage in 25 years by spending less money,” Amromin says.

How much less? Working backward, researchers figured out the difference on an annual basis: The investor who chose a retirement investment over a mortgage prepayment got to keep $400 a year in his pocket.

Amromin says the study probably underestimates potential households that would benefit by moving mortgage prepayments into tax-deferred retirement accounts, because researchers made conservative assumptions:

1. They assumed investors didn’t get a 401(k) match from their employers.
2. They presumed the investor would put the money into a low-risk investment - Treasury bonds or highly rated mortgage-backed securities.
3. They assumed individuals had a constant income tax rate over time.
4. The researchers excluded state tax obligations, which would also make the tax deductions of the 401(k) more worthwhile.

For many homeowners, including Schenke, it’s really a psychological decision.

“If I own my house, I’ve got my stake,” he says. “Housing is the biggest part of your costs, and if that’s taken care of, I feel like I can get by on a modest income. Every dollar I put into a retirement account, I feel like it’s gone for at least 20 years.”

But if someone loses their job, no mortgage lender will offer a home equity loan, whereas money in a 401(k) could be withdraw. Meanwhile, the ability to sell a home in an emergency depends on market conditions.

Why do so many people choose to put extra money into a mortgage when other options would likely increase their wealth?

“This is really remnant of Depression mentality that has persisted from generation to generation,” says Amromin.

At the time, most mortgages had terms of 1-5 years, with a lump sum payment due at the end.

“Any shock to income meant you couldn’t afford your payment - mortgages were much more susceptible to economic uncertainty,” says Amromin.

“It’s fine to pay down your home loan if it gives you peace of mind, but you should recognize what that peace of mind costs.”

SOURCE: Yahoo! Finance