Prepay or Invest? Compare the Right Two Things

Prepaying a mortgage is not an investment decision against the stock market. It is the retirement of a bond you issued (section “The Mortgage as a Negative Bond”), and its return is exactly the after-tax mortgage rate, earned risk-free. So compare it against a risk-matched alternative, not against equities:

where $r_b$ is the yield on a bond or cash instrument of comparable duration and ${\tau }_b$ its tax rate. Two consequences follow immediately, and both cut against the folk wisdom.

First, ${\tau }_{\text{eff}}$ is probably smaller than you think, which makes prepayment more attractive than the traditional advice assumes. If you take the standard deduction, the mortgage interest deduction is worth zero and the after-tax cost of the loan is the full note rate. If you itemize, the 2/37 rule caps the benefit near 35 cents on the dollar (section “Tax Deductions of The Mortgage Interest”), and interest on acquisition debt above $750,000 generates no deduction at all — so on a $1.5 million loan, half your interest is non-deductible regardless. A 6.5% mortgage at ${\tau }_{\text{eff}}=0.175$ costs 5.36% after tax, risk-free. Very few fixed-income alternatives clear that.

Second, the comparison is not against your whole portfolio’s expected return, because prepayment is certain and equity returns are not. Holding a bond allocation while carrying a higher-rate mortgage is a guaranteed negative spread; that is the negative-bond argument, and prepayment is how you close it. But this only reaches the money left after the waterfall above, because the tax-advantaged rungs beat both sides of this comparison — which is precisely the finding of the Amromin, Huang, and Sialm work quoted in section “Surviving Job Loss: How Strategic Financial Planning Can Save Your Home”: a large minority of households accelerating mortgage payments instead of funding tax-deferred accounts are simply making the wrong trade, at a cost of 11 to 17 cents on the dollar.

If you do decide to prepay, decide first what you want from it. Prepaying alone shortens the term and leaves the payment unchanged; prepaying and then recasting lowers the payment and leaves the term (section “Recasting: The Refinance Nobody Offers You”). If your motive is resilience against an income shock, neither one helps as much as the same money left liquid — the servicer wants November’s payment in November regardless of how far ahead you are.