Floating-Rate Funds vs. Paying Off Mortgage
You have the funds to pay off your mortgage early. Should you do it?
Though pulling the trigger could save you thousands in interest, you might have more to gain financially by investing in floating-rate funds.
The best choice really depends on a lot of factors. Are interest rates rising or falling? In a rising interest rate environment, floating-rate funds will pay out higher dividends, meaning more cash in your pockets.
If interest rates are falling, those funds won’t result in much revenue, and paying off your mortgage will likely net you the most financial gain in the long run.
How Floating-rate Funds Work
Mortgage loans are pretty cut and dry. You borrow money to buy a home, and you pay that loan off — plus interest—until the debt is paid off. Paying off your mortgage early would simply close out your loan and save you any future interest you would have had to pay.
Investing in floating-rate funds would instead be a move to make money, not just save it. Here’s how these funds work: Floating-rate funds invest in bonds, loans and other debts that have varying interest rates. The rates on these funds reset often — daily, weekly, monthly or sometimes annually — thus changing the yield at which the investor earns. By investing in companies with low investment ratings, floating-rate funds are designed to offer high yields when rates are up.
When rates are down, however, yields drop significantly.
Pros and Cons of Both Options
There are obviously pros and cons to both options. The advantages of paying off your mortgage are many. You save on future interest costs, you no longer have a monthly payment and your household cash flow goes up. The major downside, however, is that you don’t get those valuable tax write-offs that come with a mortgage.
If you’re early on in the loan when interest costs are high, that can mean losing a substantial deduction over the next several years. Paying off your mortgage also means less in cash reserves, which could hurt you in an unforeseen emergency.
In a nutshell, the pros of paying off your mortgage are:
Less paid in interest
No more monthly payments
More household cash flow
No more mortgage-related tax write-offs
Less in cash reserves
Floating-rate funds have their own ups and downs as well. In the right environment, floating-rate funds can mean consistent, solid income — which may even make managing those mortgage payments easier. The big detractors are that revenues are hard to predict and ever-changing (especially compared to traditional, fixed-maturity bonds) and that lower interest rates mean significantly lower dividends. When rates are down, it may also be harder to sell off floating-rate funds without losing capital.
Pros of investing in floating-rate funds include:
Potential for high dividends
May make paying down mortgage easier
Cons of floating-rate funds:
Inconsistent, unpredictable yields
Highly dependent on market performance
Low yields when rates dip
Other Factors at Work
The state of interest rates isn’t the only thing that should factor into your decision.
Paying off your loan or investing thousands of hard-earned dollars is a big move either way, so make sure you consider the full scope of your financial situation first.
Here are a few things you’ll want to take into account:
The length of time remaining on your loan term - How many years are left on your loan? Paying off the last two years of your mortgage will only net you a few thousand, at most. Could a floating-rate fund equal more in potential profits?
Your stage in life - If you’re retired and are looking to cut monthly costs, paying off your mortgage could help significantly. It could also ensure your Social Security benefits go further and that you have a paid-off piece of real estate to bequeath your heirs. If you’re in the prime of your career, you might have more time before you need a fully paid-off home. You also may have a higher income and more consistent cash flow to keep your mortgage afloat.
Your tax burden - A mortgage comes with significant tax advantages — especially at the outset. Paying off your mortgage would disqualify you from these deductions and result in a higher tax burden, a lower refund or worse, a nonexistent one. If you count on that refund or already have a high tax obligation, this could pose a problem.
Your cash reserves - Would paying off your mortgage deplete your cash reserves? As a homeowner, cash reserves are important in case of emergency. They’re also crucial to covering unexpected medical costs and other unforeseen events that could occur in life. If you do opt to pay off your mortgage, make sure you’ll still have a financial cushion just in case.
There’s also diversification to consider. Having a diverse portfolio of assets and investments can protect you if times get tough. It balances your financial risk and ensures you always have access to funds or liquid assets in an emergency. If you already have lots of investments, keeping your mortgage can give you access to a different type of capital (by way of HELOCs, home equity loans, reverse mortgages, etc.) should you need it.
Best Floating Rate Funds for 2019
Rankings from U.S. News & World Report show the Penn Capital Defensive Floating Rate Fund, the Oppenheimer Senior Floating Rate Fund and the Franklin Floating Rate Daily Access Fund as the top floating-rate fund options. One-year returns on the funds came in between 3.97 percent and 5.03 percent.
At the close of 2018, mortgage rates hovered in the same range — around 4.6 percent. Though rates dipped slightly in December, across the year, rates on 30-year mortgages rose significantly. According to Freddie Mac, 2018 saw rates kick off at 4.03 percent, jumping more than half a percent over the year. Most experts predict mortgage rates will continue rising, potentially reaching 5.8 percent by year’s end.
At the end of the day, the best choice depends on your unique financial situation, as well as the current market. Paying off your mortgage is a vote of confidence that interest rates will remain stable or even fall. Investing in floating-rate funds is a vote that they’ll rise.
Just remember: there’s no way to predict exactly when or how much interest rates will rise. If you’re not sure what the right move is, talk to a financial advisor to learn more about current market conditions before moving forward.