Pros and Cons of Mortgage Prepayment by Seniors
May 10, 1999, Revised March 17, 2009, August 28, 2011

The financial crisis has torpedoed the retirement planning of many seniors. Those with mortgage debt face the question of whether and how they should pay it off.  This is a guide on how to make decisions about mortgage repayment.

Core Principle: Repaying a Mortgage Is an Investment.

The yield on mortgage repayment is the mortgage interest rate. Repaying a 6% mortgage yields 6%, the same return as acquiring a 6% bond. Note: Bonds and mortgages have different interest compounding periods, which impacts their “effective return”, but not by enough to worry about.

Before-Tax and After-Tax Returns


 In comparing the return on mortgage repayment with the return on alternative investments that are taxable, it doesn't matter whether the comparison is made before-tax or after-tax. If you are comparing repayment of a 6% mortgage with acquisition of a 5% bond, for example, the before-tax comparison is 6% versus 5%. The after-tax comparison, assuming the borrower is in the 40% tax bracket, is 3.6% versus 3%. If mortgage repayment earns the higher return before-tax, it also earns the higher return after-tax. If income on the alternative investment is not taxable, however, returns should be compared after-tax.

The Investment Decision

In general, borrowers should repay their mortgage when their mortgage rate is higher than the return on alternative investments of comparable risk. Since mortgage repayment carries no risk, the safest application of this rule would limit alternative investments to Government securities, insured deposits and other Federally guaranteed assets. The returns available on such assets would usually be below the mortgage rate.

Borrowers can also compare the mortgage rate with returns on assets that do carry risk. To justify selecting such assets, they should carry a return above the mortgage rate large enough to justify the greater risk. But that is a difficult judgment to make, and it should reflect the capacity of the borrower to take the risk, which among other things varies with the borrower’s age.

For example, I usually recommend that seniors involved in this exercise limit their selections to fixed-income assets. Over long periods, investment in a diversified portfolio of common stock yields a significantly higher return than mortgage repayment, but the volatility of returns on stocks is very high and includes episodes of negative returns, such as the one we are in now. Seniors may not have the time to wait for such episodes to run their course.

Allocating Excess Cash Flows 

Borrowers are faced with two types of mortgage repayment decision. In one, they invest excess cash flows each month over an indefinite future period. They should allocate excess cash flow to mortgage repayment if the mortgage rate is higher than the return, adjusted for risk that can be earned that month on newly acquired financial assets. The owner confronts a new investment decision every month,

Liquidating Financial Assets to Repay the Mortgage

Many seniors are faced with a different type of decision -- whether to liquidate financial assets in order to repay the entire mortgage loan balance. In making a one-time investment decision that is irrevocable, the borrower can’t adjust to future changes in the investment rate. He has to look ahead and anticipate what these changes might be and how long he will be around.

To help deal with this problem, I developed a spreadsheet which allows a borrower to enter any scenario for future interest rates, and compare his wealth in every future month in the two cases: where he liquidates his assets to repay the mortgage at the outset, and where he retains both the mortgage and the assets. The spreadsheet is Loan Repayment Versus Investment. Seniors confronting this decision may find it instructive to play with the spreadsheet.

Anticipating a Reverse Annuity

Seniors in modest circumstances who have no interest in leaving an estate, may have a special reason to prefer mortgage repayment to asset accumulation as a way of increasing their wealth. After age 62, the equity in their house can be converted into income by taking out a home equity conversion mortgage (HECM), while they continue to live in the house. If there is a mortgage balance at the time, it must be paid off with proceeds from the HECM, which reduces the income the owner can draw.

Every Case Is Different

In individual cases, account should be taken of individual circumstances, including the senior's total wealth, age, the interest rate on his mortgages, and his tolerance for risk. The two cases that follow are illustrative.

"I have $30k remaining on my 8% mortgage, which has less than 5 years left, and I also have $10k of other loans at 12%. My stock portfolio is several times larger than my debts. I am considering the following options: a) Liquidate stocks to pay off the mortgage balance, which saves the $1,000 per month payment. Then use $500 a month to repay the 12% debt and $500 to invest in stocks; b) Liquidate stocks to pay off the 12% loans, saving $500 per month which would be invested in stocks; or c) Don't prepay any debt and watch the stocks grow at 20% annually. I am 50 years old and want to retire in 13 years…

The correct answer depends on how much risk you are prepared to take. If you were certain that your stocks would continue to yield 20%, it would be your option c. You wouldn't pay off any of your debt before you had to, and in fact you would refinance your mortgage for the maximum amount you could get and put the cash you take out into stocks. The sole reason you are contemplating repaying debt that costs substantially less than 20% is that the 20% is not to be depended on, especially in the short-term. Option c is the riskiest course of action.

The next riskiest is to pay off the 12% loan, your option b), which is what I would do. Borrowing at 12% to hold stock is too much of a gamble for my taste. If you were really risk averse, you would pay off all your mortgage as well.

Your first option, paying off the mortgage alone, makes no sense. If you are going to repay debt, you pay off the higher cost debt first.

"I have a $49000 mortgage at 8.75% with 28 years to run…At my age (76), is it worth it to me to refinance? I have no debt other than this, and have about $170,000 in cash, Treasuries and a money market fund. I need more spending money."

Rather than refinance, I would pay off the mortgage in full. Viewed as an investment, repaying a mortgage yields a risk-free return equal to the mortgage interest rate, which in your case is 8.75%. Since you have $49,000 in liquid assets earning far less than this, it is a no-brainer.

If you were wealthier, and had a significant portion of you wealth invested in the stock market earning 12-18%, I would probably counsel you to refinance the 8.5% loan. But you have limited wealth and have elected to invest it conservatively, which for someone of your age makes sense. Prepaying your mortgage in full is consistent with a conservative investment policy.

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