I Have Some of That!

Not long ago an acquaintance was speaking to me about investing and the recent stock advice from his broker. The friend wanted to know what I thought of the broker's advice to buy several oil company stocks. I told him I had no idea whether that was a good move but that my clients and I have oil stocks in our portfolios. In fact we have most of the oil company stocks. "What about investing in Brazil?" he asked. "We have some that too," I told him. "In fact," I said, "we own a portion of about 14,000 companies. If you name a company or country, the odds are we own some it." Of course, he wanted to know how that was possible.

"You see," I said, "we don't fret about whether we should be buying Exxon or whether Brazil is a good place to invest. I don't have that knowledge. No one does. It's just speculation. Since we're investors and not speculators we invest in a broad cross-section of securities in a highly-diversified fashion. That investing is done not to get the highest returns but to get the appropriate returns with the least amount of risk given our long-term financial objectives. We're all free to stop watching CNBC and reading Money magazine. We feel assured that we'll get exactly the returns the markets will produce in the future. It's a sensible, no-gimmick approach. Sure, it doesn't pay big commissions to brokers and it won't be popular on TV, but meeting our financial goals is all that matters."

My friend went away scratching his head a little, at the same time wondering whether his own life wouldn't be simpler and his financial future more secure if he just embraced sound principles of investing and eschewed speculating.

Prepay the Mortgage or Put that Money in Tax-Deferred Savings?

Many individuals are faced with the choice of increasing their mortgage payment beyond the required amount (prepaying the mortgage) or increasing their investments in tax-advantaged retirement accounts. The authors of a 2006 paper entitled, “Responsible Fools? The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings,” examined whether individuals were making choices that were financially optimal.

In general, the benefit of increasing the contribution to a tax-advantaged account is that the investment grows either on a tax-free basis (Roth accounts) or on a tax-deferred basis (IRAs, 401(k)s, profit-sharing plans, etc.). This allows for a tax arbitrage. The mortgage interest is tax deductible if one itemizes, while the earnings inside of the retirement savings account are either tax deferred or tax free. In the paper, the authors documented that, for some individuals, the tax benefit more than offsets the slightly higher rate on the mortgage (which in turn is higher than that which can be earned by investing in a mortgage-backed security of similar maturity — used by the authors because it matches the risk characteristics of a mortgage). They found that the advantage enhanced if, by increasing their investment into a 401(k) plan, individuals also received a matching contribution from their employer.

The paper concluded that 45% of individuals would benefit from the strategy of increasing contributions to a retirement savings account instead of prepaying their mortgage. Note that individuals most likely to benefit were those in higher tax brackets. According to the paper, the decision to increase retirement savings yielded incremental savings of between 11 cents per dollar (if the investment was made in Treasury instruments) and 17 cents per dollar (if the investment was made in a mortgage-backed security). Finally, they estimated the cumulative cost of inefficient decisions. They concluded, “In the aggregate, correcting this inefficient behavior could save U.S. households as much as 1.7 billion dollars per year.”

Since the above benefits are basically riskless (they are just a tax arbitrage), why did individuals forego the benefit? The authors hypothesized that, in general, a high aversion to debt (the desire to be debt free) drove an individual’s “investment” choice toward paying down the mortgage instead of increasing retirement savings.

The paper also pointed out that there are two circumstances that work in favor of prepaying the mortgage. First, those with mortgages with a loan-to-value (LTV) of more than 80 percent might consider paying down the mortgage to that level to eliminate the cost of private mortgage insurance (PMI). For those who do not itemize deductions in a lower tax bracket, the prudent choice would be to pay off the debt (particularly if it is likely one would be in a higher tax bracket when taking future withdrawals).

The second point concerns penalties that individuals would face if they were to withdraw funds early from a tax-advantaged account. Individuals who withdraw funds from such accounts before age 59 ½ would face a 10% penalty. Thus, individuals should consider whether there could be a liquidity risk — meaning a reason that might require them to withdraw funds from a tax-advantaged account before the end of the early withdrawal penalty period.

The authors acknowledged that, in a perfect world, individuals would not have to choose between prepaying their mortgage and contributing those funds to savings. When faced with a situation of “one or the other,” your individual financial profile determines the final call; but for some individuals it might be more prudent to contribute funds now earmarked for mortgage prepayment to a tax-deferred savings vehicle.