Commentary by Douglas R. Andrew on

The Tradeoff betweenMortgage Prepayments and Tax-Deferred Retirement Savings From the Working Papers of the Federal Reserve Bank of Chicago By Gene Amromin, JenniferHuang, and ClemensSialm, One of our own federalbanks-Chicago's FederalReserveBank-has determinedthat by acceleratingmortgagepaymentsinsteadofstashing money in tax-deferredaccounts,rnore than one in three Americans aremaking the "w'rongcltoice," and are giving up potentially importantarbitragegains. The mortgageoverpayments,the Fed'srecentreport says,is a "mis-allocation"offunds that costs people $ I .S-billion a year. If consumerschangedtheir allocation by not sendingexcesspaynents to their moftgage company,and insteadput that money in someform of tax-advantagedsavings,they would reapa rnediangain ofbetween 1I and l7 centsper dollar. This is the veryJirst time the Fed has comparedthesetwo kinds of "savings,"write the authors.They concludethat "many householdshave significant amountofmoney" in both tax-favoredand taxable accounts,but that a "largeproportion" of American taxpayersapparentlyue not Iaking the smarterroute to assetallocation,which would put substantiallymore money in their retirementsavings. I am delightedto seethat the Fed'sown expertsnow believe deductiblemortgageinterest can be an excellentchoicefor many taxpayersto use in structuringtheir retirernentfunding strategy,even though I do not agreewith the report'snarrow focus on only qualified plans such as IRAs and 401(k)s, What'smore, the papersays arbitrageis a "rather conservative"way of optirnizing retirernentwealth. Taxpayersgain when interestrates go up, sincethe newly investedamounteamshigher ratesthan the mortgagedebt costs.Shouldinterestrates go down, taxpaye$ still come out ahead,becausethey are "likely to exercisetheir option to refinance," thus "reducingthe downsiderisk of the arbitragestrategy." The Fed report endsby saying that despitethe risks (and rernember-there are risks associatedwith all investmentstrategies),saving retirementmoney in a tax-deferredplan "hasthe additional benefit of providing a good hedgeagainstthe combinationofhousing price risk and liquidity risk." Finally, the Fed saysthat taxpayerswith incomesover $100,000a year who usernortgage-deductible interestas part ofan arbitragestrategyin retirementaccountswould appearto havethe most to gain, and the authorsfind it "puzzling" that trore people who are in "better hnancial shape"than the averagetaxpayerdon't take advantageof this kind of strategy. I have no idea if the authorsof this FederalReservepaperhave readmy MissedFortune books or have heardof me. But it is gratifuing to seegovernmentexpertsthemselvesvalidateand support a key elementof my wealth optimization program. If you would like to readthe entirestudy,it is available at www.MissedFortune.corn/ChicagoFedStudv as found in the "working papers"sectionofthe Federal Reserve Bank of Chicago'sWeb site. The study also points out that: t "46.I percentofhouseholds areprepayingtheir mortgageby an averageof $3,l40 per year' . "only 49 percentofhouseholds relied on advice lrom professionals" . "having accessto better financial infonnation (financial advisoror personaleducation) substantiallyincreasesthe likelihood of making the right choice" The key reasonsAmericansmake thesemistakesare: o "not having resourcesto make decisions" . "greateremphasison savingshabitsthey'perceive' as rnoreliquid" r "limited information on the cost-benefitanalysis" r "rational responseto'institutional' factors" The actual quote from the abstractat the beginningofthe report readsas follows: "We show that a significant number ofhouseholds can perform a tax arbitrageby cutting back on their additional mortgagepa).nentsand increasingtheir contributionsto tax-deferredaccounts.Using data liom the Suwey of ConsumerFinances,we show that about 38% of U.S. householdsthat aro acceleratingtheir mofigagepayments insteadofsaving in tax-deferredaccountsare making the wrong choice. For thesehouseholds,reallocatingtheir savingscan yield a meanbenefit of I I to l7 centsper dollar, dependingon the choice ofinvestrnent assetsin the tax deferred accounts.In the aggregate,thesemisallocatedsavingsare costing U.S. householdsas much as 1.5 billion dollarsoer vear.,."