The Tradeoff between Mortgage Prepayments and TaxDeferred Retirement Savings

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The Tradeoff between Mortgage Prepayments and
Tax-Deferred Retirement Savings

• By Gene Amromin, Jennifer Huang and Clemens Sialm
• Discussion by Chester Spatt
• Behavioral Finance Conference
• Seventh Maryland Finance Symposium
• University of Maryland
• March 30, 2007

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• Securities and Exchange Commission (Chief
  Economist) and Carnegie Mellon University. The
  Securities and Exchange Commission, as a matter
  of policy, disclaims responsibility for any
  private publication or statement by any of its
  employees. The views expressed herein are those
  of the author and do not necessarily reflect the
  views of the Commission or of the author's
  colleagues upon the staff of the Commission.

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Why did Lemma ask me?

• Utility Player
• Mortgage Prepayments
• Asset Location and Taxes

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Basic Intuition

• Some mortgage borrowers can prepay their
  mortgages to a greater degree and therefore, have
  more funds available for tax-deferred investing
• The paper documents that many mortgage borrowers
  are accelerating mortgage payments instead of
  contributing to tax-deferred plans when they
  appear to have greater tax-deferred contribution
  capacity

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Is this a tax arbitrage?

• Non-tax frictions work against the
  strategypricing of mortgages is typically
  disadvantagedservicing fees and for a given
  creditworthy borrowerdefault spread.
• Pricing of prepayment option raises the mortgage
  rate as well given stochastic interest rates
• Full-blown arbitrage analysis

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When would borrowers rationally reduce their
mortgage rather than contributing to TDA?

• Calling loan might be optimalif contract rate is
  low vs. new money rate-term structure intuition
• Current tax rate is relatively low compared to
  future tax rates of the taxpayerso current TDA
  contribution does not deliver much tax benefit
• Mortgage interest need not be deductible
• Equity could be the marginal investment in the
  tax-deferred account, so limited benefit to
  additional tax-deferred funds
• Hedging future liquidity shocks

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Some alternative perspectives

• Prepayment sometimes optimal
• Many individuals arent prepaying mortgages
• Many individuals contribute the maximum allowed
  tax-deferred investments
• Whats the right metric for identifying puzzling
  behavior?

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Institutional Observations

• Effective early withdrawal penalty differs for
  traditional and Roth tax-deferred accounts18
  vs. 10
• What proportion of tax-deferred investing
  captured without IRAs and Keoughs?
• Bankruptcy treatment varies by tax-deferred
  product
• 50 borrowing allowance is overstatedonly
  relevant for employer plans and capped at 50,000
• Higher tax rates of young vs. old may reflect
  cohort effects and wealth, rather than rising tax
  rates

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Location Puzzle

• Investment patterns between the taxable and
  tax-differed accounts offer well-documented
  puzzles
• To the extent that various puzzles reflect the
  same underlying factors, these are not
  independente.g., contributions and investments
  in the tax-differed account intertwined
• Weakens somewhat the nature of the contribution
  here

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Mortgage Choice

• Skeptical about proportion of fixed-rate loans
  referenced (89)
• Analysis only examines 30-year fixed-rate loans
  information in other loans may provide useful
  term structure information
• Ex ante mortgage choice would be an interesting
  margin in different work (ex ante choices
  characterized under the absence of arbitrage by
  Dunn and Spatt (JF, 1999))