Prepaying Your Mortgage Might Be Your Best Investment Today

Jared Dillian  |

Every mortgage comes with an option to prepay. That may take the form of sending smaller prepayments every few months or so. Or, more commonly, it takes the form of prepaying the whole thing at once.

Naturally, you can pay off the mortgage if you move and sell the house. But even if you don’t move, you can pay off the mortgage and get another, cheaper one (if interest rates go down). This, of course, is known as refinancing.

There are calculations you can do to figure out if it makes economic sense for you to refinance your mortgage and make prepayments.

To Prepay or Not to Prepay

It makes sense to refinance your mortgage if interest rates go down. If you have a 4.5% interest rate on your mortgage, and rates decline to 3.5%, you can probably save a few hundred dollars on your monthly payment.

The same decision matrix applies to prepayments. It makes sense to send in additional principal when rates go down. That’s because you are technically earning 4.5% by prepaying your mortgage. And because interest rates have declined, opportunities to make 4.5% elsewhere are gone.

For some of you earning 4.5% is not very sexy. Au contraire. It is the sexiest thing I have ever seen. That 4.5% is a sure thing. It’s like a T-bill yield. There aren’t many opportunities to earn 4.5% risk-free anywhere these days.

If you think there are, you are probably spending too much time hanging out on StockTwits.

So the question is…When should I prepay my mortgage, and when should I invest? Should I pay off all my debt before I invest a dime?

Answer: You should pay off all debt except for your mortgage (which is tax-advantaged). You should chip away at that over time.

Liquidity is important, too. If you pay off your mortgage but have no cash for emergencies, that isn’t very smart.

Once you have paid off your car loan and your credit cards and your student loans, you can do these three things:

  1. Prepay your mortgage
  2. Save cash
  3. Invest

Your goal should be to be completely debt-free (including the mortgage) in 5-7 years.

Allocation to Home

Most people want an asset allocation that looks like this:

  • 60% stocks
  • 40% bonds

Now, are you diversified if you have stocks and bonds? Not really. So, instead you can have an asset allocation that looks like this:

  • 55% stocks
  • 35% bonds
  • 10% commodities

But we are leaving out one big thing. We are leaving out…

… real estate. In particular, your own home!

I think real estate should make up about 20-30% of your portfolio, for diversification purposes. Then, your asset allocation looks something like this:

  • 40% stocks
  • 30% bonds
  • 20% real estate
  • 10% commodities

Now, the allocation to real estate isn’t the notional value of your home; it’s the equity in your home. So a typical asset allocation might look like this:

  • $80,000 in stocks
  • $60,000 in bonds
  • $40,000 in real estate
  • $20,000 in commodities

The $40,000 here represents equity in your home. If you have a $200,000 home, and you have $40,000 in equity, you have 20% equity.

All easy enough.

Debt Is Your Enemy

You should always have a bias to pay down debt. I like mortgage debt better than other kinds of debt. But it is still debt. And the bank can still foreclose on you even if you have a one penny balance on your mortgage.

So paying down your mortgage is about eliminating risk.

This may result in you having a higher allocation to real estate than you would otherwise have. It may also result in you prepaying even when interest rates are going up. Work on paying off the mortgage, and after that, work on investing.

You will have plenty of time.

One of the coolest things in the world is having a house that is paid off. If your house is paid off, and you sell it, you get all the cash. It actually happens!

People have a hard time thinking about their house or their mortgage as saving or investing, but it really is. If you sell your house and rent somewhere, you can then take that million bucks and invest it.

If your house is paid off, all you really have to pay is the property taxes (and the cable bill, and stuff like that). You don’t even have to pay for the insurance, but you probably should.

I practice what I preach. I have about a 25% allocation to real estate and my mortgage should be paid off in a year or two.

I bought a bigger house about 3.5 years ago partly because I wanted a higher allocation to real estate. And it has been an excellent trade, even though a house shouldn’t be a trade.

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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