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With fixed income yields stubbornly low, should clients prepay their mortgage instead of investing in bonds? I argue this question is based on a false equivalence. Mortgages are not “negative bonds.” The prepayment decision goes well beyond interest savings and should consider asset allocation, risk tolerance, and liquidity.1

Prepaying a mortgage changes your asset allocation

It’s very common for clients to say prepaying a mortgage is akin to investing in bonds. This is because technically a mortgage, or indeed any borrowing, can be thought of as a short bond position. But this is myopic. A mortgage is not attached to a client’s bond portfolio any more than is a car loan or credit card balance.

There are two sensible ways of looking at a mortgage in the context of a client’s overall financial picture.

Since the mortgage is secured by a home, prepaying increases the percentage of net worth allocated to real estate. This example uses $10,000 cash to prepay some mortgage principal:

Net worth does not change because of the prepayment – we are simply reducing cash and increasing home equity by the same amount. As a percentage of net worth, home equity increases from 25% to over 31%. As an investment, therefore, a prepayment can be interpreted as reallocating a greater percentage of net worth to real estate.

I prefer an alternative view. For practical purposes, clients are on the hook for repayment of a mortgage regardless of what happens with the value of the home.2 In other words, it is more appropriate to treat a mortgage as generic debt, not attached to a specific asset. Viewed this way, prepayment shifts the allocation from cash to the other asset classes pro rata.