FEDweek

When Prepaying a Mortgage Makes Sense

When you prepay a mortgage you’re essentially investing at the mortgage rate. Paying down a mortgage reduces debt and subtracts from overall financial risk. According to some financial professionals, prepaying or reducing a mortgage can be considered an investment in fixed-income, similar to buying a bond.

In the lingo of financial professionals, prepaying a mortgage marries “behavioral finance” with “portfolio optimization techniques.” For many people, fully paying off a mortgage over a period of years is as gratifying as seeing a stock double in price.

For example, you might shift a portion of your fixed-income rather than your equity allocation to mortgage prepayments. The return from mortgage prepayments can be greater than or equal to the rate on high-quality fixed-income vehicles.

Other factors arise when weighing mortgage prepayments.

Liquidity–Taking a withdrawal from, say, a municipal bond fund to increase equity in a personal residence means giving up some access to ready cash. Homeowners who prepay a mortgage are moving money from liquid into less liquid assets.

Nevertheless, in today’s world a lack of liquidity needn’t be a serious obstacle to prepaying a mortgage. You might set up a home equity line of credit, which can be tapped if there’s a need for cash.

Risk–Comparing the return on a mortgage prepayment to the yield on an intermediate-term bond is by no means apples-to-apples. Bonds and bond funds have interest-rate risk.

That won’t happen with mortgage prepayments. There’s neither interest rate risk nor credit risk in a mortgage prepayment. If you’re not itemizing deductions–and getting no tax benefit from a mortgage–prepaying can be a way to get a 6 percent or 7 percent return, risk-free.

Peace of mind–If all of the financial factors wash, this might tip the scale. Many people like the idea of being debt-free, going into retirement.

And when stocks are falling, homeowners who are prepaying their mortgages can say, “at least I’m accomplishing something.”