Think Twice About Prepaying Your Mortgage

Don't rush to pay off your low interest, tax-deductible mortgage, according to a recent study entitled "The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings," which was authored by Clemens Sialm of the University of Michigan's Ross School of Business, Gene Amromin of the Federal Reserve Bank of Chicago and Jennifer Huang of the University of Texas at Austin. According to the study, at least 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice, a mistake which is costing U.S. households about 1.5 billion dollars per year.

As interest on a home mortgage is generally deductible, a mortgage with a 6% interest rate will only cost a taxpayer in the 25% tax bracket 4.5% in after tax dollars. Rather than paying off a mortgage which is only costing 4.5%, one could make tax deferred contributions to a 401(K) or IRA, resulting in additional tax savings. Assuming an average 8% annual return on funds invested in retirement accounts, it is easy to see that funds used to pre-pay a mortgage would be more wisely invested in retirement accounts.