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The tradeoff between mortgage prepayments and tax-deferred retirement savings

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  • Eugene Amromin
  • Jennifer Huang
  • Clemens Sialm

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 Survey of Consumer Finances, we show that about 38% 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 benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. ; In the aggregate, these misallocated savings are costing U.S. households as much as 1.5 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations or other constraints, and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-06-05.

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Date of creation: 2006
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Handle: RePEc:fip:fedhwp:wp-06-05

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Keywords: Mortgage loans ; Retirement income ; Taxation;

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Cited by:
  1. James J. Choi & David Laibson & Brigitte C. Madrian, 2011. "$100 Bills on the Sidewalk: Suboptimal Investment in 401(k) Plans," The Review of Economics and Statistics, MIT Press, vol. 93(3), pages 748-763, August.
  2. Hyrum Smith & Michael Finke & Sandra Huston, 2012. "Financial Sophistication and Housing Leverage Among Older Households," Journal of Family and Economic Issues, Springer, vol. 33(3), pages 315-327, September.
  3. Karen E. Dynan & Donald L. Kohn, 2007. "The rise in U.S. household indebtedness: causes and consequences," Finance and Economics Discussion Series 2007-37, Board of Governors of the Federal Reserve System (U.S.).
  4. Karen E Dynan & Donald L Kohn, 2007. "The Rise in US Household Indebtedness: Causes and Consequences," RBA Annual Conference Volume, in: Christopher Kent & Jeremy Lawson (ed.), The Structure and Resilience of the Financial System Reserve Bank of Australia.
  5. Gene Amromin & Jennifer Huang & Clemens Sialm & Edward Zhong, 2011. "Complex Mortgages," NBER Working Papers 17315, National Bureau of Economic Research, Inc.
  6. Justine S. Hastings & Brigitte C. Madrian & William L. Skimmyhorn, 2012. "Financial Literacy, Financial Education and Economic Outcomes," NBER Working Papers 18412, National Bureau of Economic Research, Inc.
  7. Gary V. Engelhardt & Anil Kumar, 2004. "Employer Matching and 401(k) Saving: Evidence from the Health and Retirement Study," Working Papers, Center for Retirement Research at Boston College 2004-18, Center for Retirement Research.
  8. D'Orlando, Fabio & Sanfilippo, Eleonora, 2010. "Behavioral foundations for the Keynesian consumption function," Journal of Economic Psychology, Elsevier, vol. 31(6), pages 1035-1046, December.
  9. Geng Li & Paul A. Smith, 2008. "Borrowing from yourself: 401(k) loans and household balance sheets," Finance and Economics Discussion Series 2008-42, Board of Governors of the Federal Reserve System (U.S.).
  10. Campbell, John, 2006. "Household Finance," Scholarly Articles 3157877, Harvard University Department of Economics.
  11. Anthony Webb, 2009. "Should You Carry A Mortgage Into Retirement," Issues in Brief ib2009-9-15, Center for Retirement Research, revised Jul 2009.
  12. Marekwica, Marcel & Schaefer, Alexander & Sebastian, Steffen, 2013. "Life cycle asset allocation in the presence of housing and tax-deferred investing," Journal of Economic Dynamics and Control, Elsevier, vol. 37(6), pages 1110-1125.
  13. Geng Li & Paul A. Smith, 2009. "New evidence on 401(k) borrowing and household balance sheets," Finance and Economics Discussion Series 2009-19, Board of Governors of the Federal Reserve System (U.S.).
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