Decision Time: Pay Off a Mortgage or Add to IRA?

When the housing market brakes, millions of homeowners who think they are going to stay in their home for a while start asking one big question:

Is it time to pay down the mortgage?
After all, adding extra money to your home loan payment isn’t only a way of paying the note off early, it will cut total interest expenses and give you peace of mind at a specific time.

Want to get rid of the mortgage before children enter college or before you retire? Simply want to build equity, so that if you need to get a second mortgage, you enhance your borrowing power?

Yet there are cases when early payoffs aren’t the best economic strategy. You may be better off contributing to your retirement accounts.

Those who choose the paydown route over contributing to tax-deferred IRAs may be losing about $1.5 billion a year, according to a recent study.

That’s because early payers could reap higher long-term gains by investing in fixed-income securities in their retirement account.

About 38 percent of U.S. households may be making the wrong choice, says a working paper by the National Bureau of Economic Research.

It was written by Eugene Amromin of the Federal Reserve Bank of Chicago, Jennifer Huang of the University of Texas at Austin, and Clemens Sialm at the University of Michigan Business School.

The trio examined data from the U.S. Survey of Consumer Finances and took 10.5 million households that prepay their home mortgage loans and contribute to a retirement plan.

Those who the researchers said weren’t getting the best return on their mortgage paydown can be unaware of the extent of “tax arbitrage profits,” or the benefits of getting a write-off and tax deferral on their retirement-plan contributions.

“For these households, reallocating their savings can yield a mean benefit of 11-17 cents per dollar, depending on the choice of assets in the tax-deferred account,” the authors contend.

The researchers are disputing the conventional wisdom of debt aversion.

Isn’t it better to be debt-free and then have that money to save for retirement or to boost cash flow?

One pitfall of mortgage loan paydowns is that they offer no immediate economic benefit. When you pay back principal, you get an imputed or assumed return of roughly the rate of your mortgage. Yet it doesn’t necessarily compound tax deferred as it would in a retirement account.

As an investment, your home offers you no dividends or diversification, especially if you have little in the way of stocks or bonds.

Investing in a mutual fund that packages home mortgage securities, real estate, U.S. Treasuries or Treasury inflation-protected securities reduces your dependence on the housing market, which is in decline in the U.S.

The retirement-funding strategy isn’t without risks. U.S. mortgage rates can rise, while inflation and defaults can depress bond prices.

The only guaranteed investments are Treasury or inflation-protected securities that you hold to maturity. You need to compare returns to see which strategy works best.

“A higher home loan rate makes it less profitable to stop prepaying, while a higher investment return makes it more attractive to invest in a tax-deferred account,” the researchers say.

Neither route gives you complete liquidity, though.

If you need to tap retirement funds—a bad idea because they are harder to replace the older you get — a 401(k) loan is a possibility, though you will have to pay it back if you quit or change employers.

Otherwise, you will pay full tax on the amount plus a penalty.

SOURCE: Chicago Tribune