Jack M. Guttentag The Mortgage Professor

One consequence of the financial crisis has been to make investment in mortgage repayment increasingly attractive. Mortgage repayment is a riskless investment that yields a return equal to the interest rate on the repaid loan. If the loan carries a 6.125 percent rate, the borrower earns that rate on the balance repaid. The yield on other investments of comparable risk, including government securities, CDs, and money market funds, are way down. My money market funds today are yielding barely more than 1 percent.

Not so obvious but even more compelling, some borrowers in the process of refinancing can earn a much higher return on partial loan repayment if the balance reduction allows them to reduce or avoid mortgage insurance coverage. The return is high because the crisis has increased mortgage insurance premiums. Here is an example from my mailbox:

"My credit is excellent, my income is adequate, my rate is 6.125 percent, and I qualify for 5.125 percent, except for one thing: The value of my house has declined from 360K to 280K, and we owe 242K. My lender says that for us to refinance we need mortgage insurance, which was not required when we took out the loan originally. I don't want to pay for mortgage insurance..."

Ditching Mortgage Insurance

If this borrower can come up with 18K to pay down the balance to 224K, that balance would be 80 percent of the current appraised value and no mortgage insurance would be needed. Relative to remaining with her current mortgage, the 18K investment would yield 18 percent over 5 years. The return is not very sensitive to how long the borrower has the mortgage; it will be a little higher if the period is shorter and a little lower if it is longer. The return includes the lower payment over the 5 years plus the smaller loan balance at the end of the period. If the loan runs to term, the return would be 16.6 percent.

If this borrower does not have the needed 18K, she should refinance anyway and pay the mortgage insurance, because she will be better off. Relative to paying an insurance premium of .62 percent, investing 18K to avoid it will yield about 13 percent over five years.

Similar logic applies if a partial prepayment converts a super jumbo into a conforming jumbo. Because the crisis has increased the yield spread between them, the return on an investment in prepayment can earn a sizeable return for a refinancing borrower.

"I have a jumbo mortgage with a balance of $809,000. I can refinance it at 5 percent for 15 years, or I can pay down the balance to $729,000 and borrow that amount for 4.375 percent. Other costs are about the same. Is this a good way to invest $80,000?"

I calculate the yield on the $80,000 investment to be 10.4 percent over five years, and, since there is no risk, it is a very good investment indeed. The yield is a little higher if you terminate earlier, a little lower if you terminate later. It is not as high as in the previous case because the investment required to lower the rate is substantially larger than the investment required to eliminate mortgage insurance in the previous case.

If the existing balance is $769,000 instead of $809,000, the investment required to convert the new loan from super jumbo to conforming jumbo would be reduced to $40,000. In this case, the rate of return over five years would rise to 15.4 percent.

In general, the yield on investment in balance reduction will be above the rate on the mortgage that is paid down by an amount that is larger a) the larger is the rate difference between the super jumbo and conforming jumbo mortgages and b) the smaller is the required investment.

Note: I did all these calculations on a hand calculator with financial functions. These are available today for about $20; look for the tell-tale symbols: N, I, PV, PMT, and FV.