Estimated reading time:2 minutes, 27 seconds
While many people have a 15-year or 30-year mortgage, it’s always advisable they pay the loan off early. Not only is it advisable, but it is totally possible. So, if you are asking yourself if you should pay off your mortgage loan early, the answer is yes– especially if you can afford to do so. Here’s why.
There is one downside to paying off a mortgage early. But, that actually falls on the investor, not the homeowner. This is called a “prepayment risk”. Basically, this is the risk investors face when a mortgage is paid off early. If it’s paid off early, investors won’t receive continued interest payments off the loan. At the same time, homeowners won’t pay continued interest payments when the loan is paid off early.
An example of a prepayment risk is a mortgage-backed security. Often times, third parties like government agencies or banks will purchase mortgages and bundle them together into a mortgage-backed security.
People who invest in these securities receive payments based on the principal interest payments from each individual mortgage. These are risky for investors because a homeowner may default on the loan or prepay the loan early, preventing the investor from receiving interest payments.
When might homeowners choose to prepay their mortgages?
- If they refinance their mortgage. Many homeowners refinance their mortgage to take advantage of lower interest rates.
- If they decide to sell their home.
- If a homeowner’s house is destroyed, their insurer may end up prepaying the mortgage due to the damage.
Investor-Friendly Calculation Tools
Luckily for investors, there are tools that can help calculate how likely a loan or pool of loans will be paid off early and what the expected return rate will be.
One tool is called “condition prepayment rate” or CPR. If you have a CPR rate of 10%, for instance, then that means there is an expectation that 10% of the loans in a loan pool will prepay over the next year.
This rate is calculated based on historical data of the underlying loan pool. For example, some borrowers may tend to pay off loans early while others do not. This will be reflected in the CPR.
Less Stress To Invest
If you are an everyday investor, it usually isn’t worth the effort to research and invest in individual mortgage-backed securities. Holding mutual funds that contain mortgage-backed securities as part of a larger mix of corporate or government bonds makes way more sense.
If you’re looking for even less stress with investing, you may want to look into exchange-traded funds. These are run by skilled managers who can help reduce the risk of investing and achieve the best returns.