Should You Pay Off a Florida Mortgage Early?

It seems like an easy call, but some experts’ guidance regarding this age-old financial question may surprise you.

Jim Schenke set aside a full year’s salary in an emergency fund, because he and his wife decided she would stay home after their daughter was born 18 months ago. That cut their $50,000 income significantly.

Their cars and student loans are paid off, and they studiously avoid credit card debt. Schenke also makes an extra payment each year toward his fixed-rate, 30-year mortgage, which has an interest rate of 6 percent.

But he doesn’t contribute to his employer’s 403(b) plan; Purdue sets aside $5,000 annually for his retirement.

“The only company I owe money to is my mortgage lender, and I’m going to be beholden to them for as short a time as I can be,” says Schenke.

But a new study suggests Schenke might be better off putting that extra cash into his employer’s retirement plan. Researchers found at least 4 in 10 homeowners would build more wealth by putting extra home loan money into a tax-deferred retirement plan.

An estimated 23 million homes face the mortgage prepayment vs. retirement savings dilemma. Switching the money to retirement savings would save U.S. households up to $1.5 billion a year, they estimate.

“The study is about making optimal use of savings,” Gene Amromin, financial economist with the Federal Reserve Bank of Chicago, says. “If you were to move a dollar from here to there without increasing risk, would you come out ahead?”

Using data from the Federal Reserve, the researchers examined individuals who had a fixed-rate home loan with either a 15-year or a 30-year term on which they made extra mortgage payments.

The people involved were eligible to participate in a tax-deferred account for retirement and weren’t maxing out contributions; and took advantage of the mortgage interest deduction by itemizing tax returns.

In the end, it’s important to do the math before you make a decision.

Consider a homeowner who takes out a 30-year fixed-rate Florida mortgage at 6 percent, and is in the 25 percent tax bracket; he effectively pays 4.5 percent on the mortgage.

“If you invest in Treasuries in your 401(k) plan that are earning 5 percent tax-free, that’s a risk-free way of increasing your return,” Amromin says.

Researchers examined household goals for prepaying a Florida home mortgage, and looked at what would happen if they invested the money in a retirement plan instead. For example, in the interest of making an apples-to-apples comparison, the researchers considered two investment scenarios:

Scenario A: The investor puts an extra amount toward his mortgage each year, paying off a 30-year fixed mortgage in 25 years.

Scenario B: The investor puts the extra cash in his 401(k), investing it in Treasury bonds or mortgage-backed securities. After 25 years of paying the mortgage at a normal rate, the investor withdraws a lump sum from his 401(k) to pay off the house - incurring income taxes (along with a 10 percent penalty if the money is taken out before age 59.5).

Although mortgage rates, income tax rates, and 401(k) contributions vary among households, in about 40 percent of the cases, putting the money into a retirement fund beat paying the mortgage off early.

“Basically, the investor met exactly the same goal of paying off the mortgage in 25 years by spending less money,” Amromin says.

How much less? Working backward, researchers figured out the difference on an annual basis: The investor who chose a retirement investment over a mortgage prepayment got to keep $400 a year in his pocket.

Amromin says the study probably underestimates potential households that would benefit from switching a mortgage prepayment into a tax-deferred retirement account, because researchers made conservative assumptions:

• They assumed investors didn’t get a 401(k) match from their employers.
• They presumed the investor would put the money into a low-risk investment - Treasury bonds or highly rated mortgage-backed securities.
• They assumed individuals had a constant income tax rate over time.
• The researchers excluded state tax obligations, which would also make the tax-advantaged features of the 401(k) more worthwhile.

For many homeowners, including Schenke, it’s more of a psychological decision than a financial one.

“If I own my house, I’ve got my stake,” he says. “Housing is the biggest part of your costs, and if that’s taken care of, I feel like I can get by on a modest income. Every dollar I put into a retirement account, I feel like it’s gone for at least 20 years.”

But if someone loses their job, no lender will offer a Florida home equity loan, whereas money in a 401(k) could be withdrawn. Meanwhile, the ability to sell a home in an emergency depends on market conditions.

Why do so many people put extra money into a Florida mortgage when other options would likely increase their wealth?

“This is really remnant of Depression mentality that has persisted from generation to generation,” says Amromin.

At the time, most mortgages had one- to five-year terms, with a lump sum payment due at the end.

“Any shock to income meant you couldn’t afford your payment - mortgages were much more susceptible to economic uncertainty,” says Amromin.

“It’s fine to pay down your mortgage if it gives you peace of mind, but you should recognize what that peace of mind costs.”

SOURCE: Yahoo! Finance