The Independent Market Observer

Where to Put the Money? How About Prepaying Your Mortgage

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 24, 2014 12:27:28 PM

and tagged Investing

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prepaying your mortgageThe dilemma many investors face, when looking at today’s markets, is simple: Where can I put my money? Markets are overvalued, and bonds sure look like a bubble, but I have to do something with the cash. I can’t just let it sit there, right?

I get it, but I don’t necessarily agree that you need to do something. Many great investors see sitting on their hands when market conditions are unfavorable as a key to their success. In poker, you make your money by not betting on bad hands. The value of the optionality associated with cash is, in my opinion, underrated.

Nonetheless, there are a couple things the average investor can do right now with some of that cash. One option is to start prepaying your mortgage.

Why prepay?                                                              

To illustrate the potential benefits of prepaying your mortgage, let’s look at an example:

  • My own mortgage has about 25 years to run, annual payments of around $15,000, and a balance of around $300,000.
  • The actual payments (the cost to me) will continue to be 5 percent per year for the next 25 years.
  • This is a risk-free payment—that is, I have to make it or lose my house.

Let’s flip this around, and consider my mortgage as a 25-year, 5-percent-coupon bond, which makes sense assuming the house will (knock wood) be worth at least the present amount of the mortgage if I sell it then—and probably more, with the effects of inflation over time. Again, this is risk-free, in the sense that I have to pay it or lose the house. It’s also nontaxable, in that the value of my home as a place to live isn’t taxable.

Paying off the mortgage today, for $300,000, would generate the equivalent benefit of a 25-year, risk-free, nontaxable bond yielding 5 percent, in the form of the payments I’d no longer have to make. With 30-year Treasuries now yielding 3.3 percent, before federal taxes (and with even that yield subject to inflation risk), a mortgage payoff presents some fairly attractive relative yield characteristics.

Conventional wisdom, of course, would say don’t prepay, because of the tax benefits. Looking at the interest rate of 4 percent, I pay around 2.4 percent after taxes. Prepaying makes no sense if I can invest the money to get more than 2.4 percent, right? Notionally, this is certainly true, but that 2.4 percent also has to take into account risk, taxes on gains, and inflation. The prepay bond, at 5 percent, looks like a reasonable bet.

A slow and steady approach

For most people, I wouldn’t recommend prepaying the mortgage all at once, as that would likely represent a big portion of your net worth. It’s simply too concentrated and too risky over time. Housing values, as we recently learned, can go down as well as up.

You can, however, very reasonably take some of your savings and make a small monthly prepayment, viewing it as a 25-year (or whatever) risk-free bond. Over time, those payments can add up. I’ve been doing this for years, and the interest savings have become substantial.

Prepaying your mortgage is an appealing strategy given today's very low expected returns on both stocks and bonds, in the low to mid-single digits. If interest rates rise, or the market becomes more reasonably valued, expected returns will rise—and prepaying your mortgage will look less attractive.

At the moment, though, prepaying is a simple but effective way to diversify your savings with an eye to reducing risk.

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