Bond Alternative: Prepay Your Mortgage - TheStreet

Savvy investors know that one of their most important decisions is how to divide a portfolio between stocks, bonds and cash. But how do you invest new money when one class flashes red?

That’s the problem today with bonds. Yields are terribly low, just 3.7% for the 10-year U.S. Treasury note. And prices could fall in the next year or two if interest rates rise, as many experts expect. That’s because investors won’t pay the full face value for an older bond if newer ones offer higher yields.

So here’s an alternative: Instead of making fresh investments in bonds or bond funds, think about paying down your mortgage.

Like bonds, mortgage prepays are essentially fixed-income investments, with the yield equal to the mortgage interest rate. If your mortgage charges 5%, 6% or 7%, that’s what you’d earn by making extra principal payments, since you’d be reducing interest charges. That certainly beats the current yield on 10-year Treasuries.

On top of that, a mortgage prepay does not carry a risk of loss if interest rates rise, as a bond does.

That’s not to say there are no risks. One is that a mortgage prepay is a long-term, illiquid investment. If bond yields were to soar to, say, 7% or 8%, it would be difficult and expensive to get your money out of the house to invest in bonds. You’d have to sell the home or take out a new mortgage or home equity loan.

There’s also the risk your home could lose value. So long as you kept the home, that would not affect the return on your mortgage prepay, since the debt would have to be paid off no matter what the home is worth. But a prepay would certainly not make sense if you were to abandon the home or lose it in foreclosure, as all your equity would be lost.

A prepay also would not be suitable if you expect to use interest earnings for living expenses, since the yield would come in the form of reduced interest charges over the loan’s life, not a regular flow of cash.

With fixed-rate mortgages, prepays cause the loan to be paid off earlier, because more of each month’s payment goes to paying down the debt. Monthly payments remain the same until the loan is retired. Use the Mortgage Loan Calculator to figure savings.

With adjustable-rate loans, prepays reduce the outstanding debt when the loan resets, typically every 12 months after an initial fixed-rate period. New monthly payments are figured by applying the new interest rate to the remaining debt for the number of years left in the original loan term.

If the interest rate were to remain the same, a prepay would reduce the required payment. The loan would not be paid off earlier unless you chose to continue making larger-than-required payments.

It’s not possible to nail down interest savings when prepaying on an ARM because you don’t know the rates it will charge in the future. But it’s probably safe to assume that if bond yields go up your mortgage rate will probably rise as well, so the yield on a mortgage prepay could well stay in line with yields you could earn on other investments.

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