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Clients got an extra dollar? Don't let them use it to pay down the mortgage, says a recent Fed study. They'll earn at least 1% more a year by investing extra cash in their retirement plan rather than their home. It's a tax arbitrage strategy that benefits almost every client, but especially those in the higher tax brackets. Clients who are making accelerated mortgage payments and not contributing the maximum to tax-deferred retirement plans are making a big mistake According to the authors, "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." The average benefit is about 11 to 17 cents on the dollar over the term of the mortgage, depending on the choice of investments inside the tax-deferred account (TDA), they say. And large investment risks aren't necessary. In order not to change the aggregate risk level of the portfolio, the authors assumed that retirement assets were invested in either Treasuries or mortgage-backed securities. Their conclusion: As long as the pretax returns on the retirement accounts are greater than the after-tax rates on the mortgage, "households are generally better off saving in a TDA instead of prepaying their mortgage." Choosing a short-term mortgage (less than the standard 30 years) is considered the same as making prepayments on a regular mortgage. In both cases, the homeowner is paying down the mortgage faster than necessary when these extra payments could be directed to a retirement account instead. The study assumed the following:
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This arbitrage strategy is always feasible since it is "self-financed." It's like taking an amount of monthly income and deciding which of two pockets to put it into debt reduction or retirement savings. They both serve to increase a client's net worth. In the end, clients can have either a large mortgage and a large retirement fund with which to pay it off, or a small (or zero) mortgage and a small (or no) retirement fund. But the tradeoff is not equal. According to the study, the tax arbitrage opportunities that arise when the pretax investment rate on the retirement fund is higher than the after-tax rate on the mortgage mean that more is going into the pocket that increases the retirement fund than the one that pays down the mortgage. How much more? The difference amounts to about 1% a year if the tax-deferred account is invested in mortgage-backed securities, or slightly less if invested in Treasuries. Whichever way interest rates go, the client wins. If the tax-deferred account is invested in a mutual fund composed of mortgage-backed securities, a rise in rates will allow newly invested amounts to earn higher rates than the corresponding liability (the fixed-rate mortgage). On the other hand, when rates go down, households can exercise their option to refinance their mortgage. A zero mortgage may not be the safest bet. The authors point out that concerns for future liquidity needs may prompt households to accelerate home equity build-up. But if house prices fall drastically, much of that equity can be wiped out. Building up assets in the tax-deferred account may provide a greater safety net against job loss or other emergency, even if early withdrawal penalties apply. Clients in high tax brackets benefit the most. The study assumed a constant tax rate over time, but the ideal tax arbitrage scenario would be for tax-deductible retirement plan contributions to be made when the client's tax rate is high and for taxable withdrawals to be made when rates are low. Employer matches and state tax deductions enhance the benefit even more. Additional funds contributed by employers and the state tax deduction for the retirement plan contribution were not incorporated into the study, but it's obvious that they would make the strategy even more profitable. Why do people engage in "inefficient behavior"? The study found that 38% of households that prepay their mortgages could benefit from the proposed arbitrage strategy. In all, these misallocated savings are costing U.S. households as much as $1.5 billion per year. Why do these households insist on paying down their mortgage when they would benefit more from putting the extra money into a tax-deferred retirement account?
What should you recommend to clients? It can be risky to recommend that clients pile on debt in order to invest the loan proceeds, but this study suggests a much gentler approach. For one, it does not advocate taking on more debt, but rather decelerating the rate at which the existing mortgage is paid off. Second, it supports contributing more to tax-deferred retirement plans, a recommendation that is hard to find fault with. If this tax arbitrage opportunity helps clients look at both sides of the balance sheet, it may indeed lead to more appropriately aggressive borrowing and investing strategies, especially among baby-boomer clients who have lots of home equity and inadequate retirement savings. It could even be argued that with so much home equity, their overall portfolio is not very well diversified. Tapping the equity and investing the proceeds such that returns exceed the loan rate by even a point or two may be a wiser strategy than the seemingly "safer" and more "responsible" route of minimizing debt. If the investment returns are tax-deferred while the mortgage interest is tax-deductible, so much the better. (Note: There are limits on the tax deductibility of home equity loan interest, so be sure to have clients consult their tax advisors.) Regardless of how far you want to take the borrow-and-invest-the-proceeds strategy, you might start by identifying clients who are prepaying their mortgages without having maxed out their contributions to retirement plans. Show them this study and suggest that they direct the extra loan payments to one or more of the following plans for which they are eligible:
Then, if you think it's appropriate for the client, begin to explore an expanded version of the borrow-and-invest-the-proceeds strategy, which may involve investing in taxable accounts and diversifying beyond fixed income into equities and alternative investments. There s nothing like a burgeoning investment account to help debt-averse clients understand that the ultimate goal is not just lower debt but higher net worth. Sometimes this is better accomplished by increasing the asset side of the balance sheet through regular contributions and smart investing. |
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