Maximize Your Wealth First: Don’t Prepay the Mortgage

In a recent research report, economists for the first time posed a very specific and very common question: ‘‘If I have extra money for savings, should it go toward retirement or paying down my mortgage?”

Some conclusions of the report were:

‘About 38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice,” says the report by economists Gene Amromin of the Federal Reserve Bank of Chicago, Jennifer Huang of the University of Texas at Austin and Clemens Sialm of the University of Michigan.

”Instead of trying to maximize their wealth, people pay more attention to getting rid of their debt,” Amromin said. ”They are not a dispassionate comparer of dollars and cents. Somehow a dollar you owe is worth more than a dollar in your pocket.”

The study found that U.S. households making the ”wrong” choice by paying off the mortgage early cost themselves a collective $1.5 billion per year, forgoing a yield of 11 cents to 17 cents for each dollar misallocated.

Consumers making the ”right” choice to prepay their mortgage were largely those who didn’t itemize tax deductions and those who already maxed out their retirement contributions, Amromin said.

Using themes from the research paper Gregory Karp of Spending Smart, asks and answers the following question:

Whether to invest for retirement in a tax-deferred plan — the only type addressed in the research — or pay down your mortgage?

One of his recommendations is using a formula I had never heard of. The Decision Formula:

…Once you’ve reached the employer’s 401(k) match, write down three numbers. Two are easy: your mortgage interest rate and your federal tax rate.

The third number is how much you think the extra money will earn in your 401(k). This needs to be a very conservative number, such as the return on a government bond. Why? Because each dollar used to pay off your mortgage early is a guaranteed return — you are guaranteed not to have to pay interest on that dollar. So to be fair, its return should be compared with the 401(k)’s least-risky return.

The formula is to multiply your mortgage rate by 1 minus your tax rate. Compare that return to what you think you can get in the least-risky 401(k) choice. Choose the higher one.

For example, if your mortgage rate is 6 percent and your tax rate is 25 percent, the math is 6 times 1 minus 0.25 (or 6 times 0.75). The result is 4.5 percent. That’s your real mortgage rate when you consider the mortgage tax deduction.

If government bonds are paying 5 percent, you should choose retirement investing over mortgage prepayment.

That’s a pretty simple yet useful calculation! Using that calculation I am better off not prepaying our mortgage although I do try and make one extra payment per year. What did your real mortgage rate turn out to be?

Read the full story: Prepaying mortgage not always best.