Personal Finance

Prepay mortgage or invest the money

Many investors juggle with mortgage payments as well as making regular contributions to their investment accounts. The question that sometimes come up is whether does it makes sense to prepay (i.e. make additional payments) the mortgage or invest the money.

Larry posted (49553) a paper that discusses the advantages and disadvantages of prepaying mortgage payments versus investing the money in tax-deferred accounts. Here’s the abstract:

We show that 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 (TDA). Using data from the three latest Surveys of Consumer Finances, we show that more than 45% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean tax benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these mis-allocated savings are costing U.S. households as much as 1.7 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity or other constraints, and that self-reported debt aversion and risk aversion variables explain to some extent the household preference for paying off their debt obligations early and hence their propensity to forgo our proposed tax arbitrage.

Disclosure of conflict of interest

When the client is ill-informed about certain products, does disclosure of conflict of interest by the advisor help? This paper, in the Journal of Legal Studies, has an interesting viewpoint, arguing that disclosure can have perverse effects instead. I think this is because the disclosure lulls the clients into thinking that they are in good hands and reduce their guard as a result.

The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest

Abstract: Conflicts of interest can lead experts to give biased advice. While disclosure has been proposed as a potential solution to this, we show that disclosure can have perverse effects, and might even increase bias. Disclosure may increase bias because advisors feel morally licensed and strategically encouraged to exaggerate their advice even further from the truth. As for those receiving the advice, proper use of the disclosure depends on understanding how the conflict of interest biased the advice and how that advice impacted them. Because people lack this understanding, disclosure can fail to solve the problems created by conflicts of interest.

The yield curve and predicting recessions

Interesting paper by Jonathan Wright that studies the use of the slope of the Treasury yield curve as a leading economic indicator, with inversion of the curve being thought of as a harbinger of a recession. He considers a number of probit models using the yield curve to forecast recessions. The paper concludes that

Consistent with recent work by Ang, Piazzesi, and Wei (2005) on forecasting growth, I have found that there is more information in the shape of the yield curve about the likely odds of a recession than that provided by the term spread alone. Probit models forecasting recessions that use both the level of the federal funds rate and the term spread give better in-sample fit, and better out-of-sample predictive performance, than models with the term spread alone.

Link HERE.