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Pay It Down

Jonathan Clements  |  August 17, 2019

DECIDING WHETHER to buy bonds or pay down the mortgage used to be a tricky decision. Not anymore: Paying extra on your home loan will almost always be the right choice.

This takes some explaining—because it involves wrapping your head around the standard vs. itemized deduction, investment taxes, and a mortgage’s shifting mix of principal and interest.

First, let’s dispense with the obvious objection: Yes, if you’re inclined to buy stocks rather than pay down the mortgage, that should indeed deliver a better long-run return. But that isn’t what we’re discussing here. Rather, at issue is whether to buy bonds or pay extra on your home loan.

This is a choice many folks face. Almost everybody should have at least some bonds in their portfolio. Meanwhile, 66% of homeowners carry a mortgage, according to Federal Reserve figures. To understand why paying down that mortgage will usually be better than buying bonds, imagine an elderly aunt just died and generously left you $100,000—and you’re mulling three possibilities.

Option No. 1: Buy $100,000 of high-quality corporate bonds in your taxable account. The bonds yield 3%, so that’ll mean earning $3,000 or so in annual interest. Problem is, you’re in the 22% federal income-tax bracket and a 3% state bracket, so you’ll lose a quarter of the interest to taxes. After that hit, you’d be left with $2,250 in annual interest, equal to a 2.25% after-tax yield. That doesn’t sound so great.

Option No. 2: Buy the 3% bonds in a retirement account. That would allow you to avoid paying taxes each year on the interest. Problem is, there are annual contribution limits on retirement accounts, so it could take years to shovel the $100,000 into a retirement account.

Your cousin, however, suggests a clever alternative: Move $100,000 from stocks to bonds within your retirement account, while simultaneously using your $100,000 inheritance to buy a total U.S. stock market index fund in your taxable account. That would leave your overall stock exposure unchanged, while allowing you to hold your bonds in a tax-sheltered account.

The $100,000 in the total U.S. stock market index fund might pay some 2% in dividends. But those dividends should qualify for the special 15% federal tax rate, so the annual tax bill will be far less than if you’d used your taxable account to buy corporate bonds yielding 3%. Those corporate bonds will, instead, be sitting in your retirement account, where the 3% will compound tax-deferred. Let’s say the bonds sit there for 20 years, at which point you pull the money out.

If it’s a Roth account, there would be no tax bill on the withdrawal, so your 20-year annualized return would be an after-tax 3%. If it’s a traditional retirement account, you’d have to pay tax on the $80,611 in interest you earned over the 20 years. If you’re still in a 25% combined federal and state tax bracket, that would leave you with $60,458—equal to a 2.39% after-tax annualized return over the 20 years. (A nerdy aside: If you figure in the tax deduction from when you first funded the traditional retirement account, the effective after-tax annual gain would be 3%, the same as the Roth. To understand why, click here.)

“Your itemized deductions are only trimming your tax bill to the extent that they exceed your standard deduction. That’s now less likely, thanks to 2017’s tax law.”

Option No. 3: Pay down your mortgage. Let’s assume you have $100,000 still owed on your house, the same amount as the inheritance you just received. The mortgage has a fixed rate of 4% and you claim the standard deduction, so you’re getting no tax benefit from all the mortgage interest you pay.

Result: You’ll pay around $4,000 in mortgage interest over the next year and—because you aren’t getting any deduction for that mortgage interest—you’ll be out of pocket by the full $4,000. On top of that $4,000, you’ll need additional money to pay that portion of each mortgage payment that gets put toward the loan’s principal balance.

The upshot: Paying off the mortgage, and avoiding the $4,000 in interest, looks like a better deal than buying bonds, no matter which investment account you use. Seem reasonable? I can imagine four possible objections to the above analysis:

1. What if you itemize your tax deductions and hence you get some tax benefit from the mortgage interest you pay? In 2019, the standard deduction is $24,400 if you’re married filing jointly, $18,350 if you file as head of household and $12,200 if you’re a single individual. Your itemized deductions are only trimming your tax bill to the extent that they exceed your standard deduction. That’s now less likely, thanks to 2017’s tax law, which boosted the standard deduction while simultaneously capping the itemized deduction for state, local and property taxes at $10,000.

Let’s say you have a 4% mortgage, you’re in a 25% combined federal and state bracket, you pay $12,000 in annual mortgage interest—and your itemized deductions are $6,000 above your standard deduction. Result: Half your mortgage interest is effectively tax-deductible, so your after-tax mortgage rate would be 3.5%. (If all the interest was deductible, the after-tax rate would be 3%.) That 3.5%, which is the cost you’d avoid by paying down your mortgage, is still higher than what you could earn on corporate bonds—plus the return from paying down the mortgage is guaranteed, which isn’t the case with the bonds.

2. Is it safe to assume that your mortgage rate will be higher than the yield on corporate bonds? If you’d taken out a mortgage when rates were below today’s level, this won’t necessarily be true—but most of the time it will be. The fact is, you and I are considered less creditworthy than large corporations, so we typically pay a higher interest rate when we borrow.

3. What if you can stash money in an employer’s retirement plan where you get a matching contribution? If you fund a 401(k) or 403(b), you might get a match of, say, 50 cents for every $1 you contribute up to 6% of pay. That’s like an immediate 50% return on your money, so there’s no question you should take advantage. But once you’ve contributed that 6% of pay, you might direct additional dollars toward paying down your mortgage—unless you plan to use those additional retirement account contributions to buy stocks.

4. What if you’re far along with your fixed-rate mortgage and relatively little of each monthly payment is going toward interest? This is a misunderstanding that trips up many folks: Because they’re paying less in total mortgage interest each year as they gradually whittle down the loan balance, they imagine they’re also paying a lower interest rate.

That simply isn’t the case. Suppose you bought bonds yielding 4% and you sold some each year. The annual amount of interest you earn would decline, but the interest rate you’re earning remains the same. It’s the same with a mortgage—which means paying extra on the mortgage continues to make sense, even if the total dollar amount of interest you’re paying is relatively modest.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Saving OurselvesWhither Vanguard and Thinking Out Loud. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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Plug McGregor
Plug McGregor
9 months ago

Jonathan – Big fan since the 90s and learned so much from you. We’ve maxed my simple ira, spouse’s government 457, my roth, an HSA. Last year started paying HSA eligible expenses out of pocket. My questions:
1) Mortgage is 3.15%, 6 years left, $75k owed. Just made last $400 monthly car payment. Considering putting much of the $400 toward mortgage. If I did consistently I’d take 2.5 years off mortage and save $2,600 in interest. How does doing this compare to making sure we just let the HSA fund grow and not use it for reimbursement? (Hopefully we can do both pay mortgage head of schedule and let HSA dollars grow, but I’m not convinced we have quite enough cash flow for this.) Paying off early would happen about the same time oldest of two starts college.
2) Not sure how to treat the HSA invested dollars in terms of risk. Right now, I treat kind of as a half emergency fund/half retirement and have it invested in Vanguard Retirement Income (30%/70%) through Schwab. Seems too conservative for a retirement fund and too risky for an emergency fund.

Any thoughts you have would be appreciated. Know this is hardly a complete picture. Thanks!

Moshe Kaye
Moshe Kaye
1 year ago

One additional issue to consider. By paying down principal you have changed a liquid asset, cash or cash equivalents, into a non liquid, non income stream generating asset, your home. You would most likely be better off in the long run by taking the extra cash and investing it in a total stock market fund, reinvesting the dividends as you go. After all it is easy to pay your mortgage with cash or CEs but much harder to pay your bills with a part of your home. Home Equity Line Of Credit (HELOC)’s may be a good solution to this problem but perhaps that is a discussion for another post.

Raj Sundaram
Raj Sundaram
1 year ago

It sounds logical but I’m not sure if I’d be able to do it. I currently don’t have a mortgage but we’ve been saving up to buy a house for mostly next year or so. I don’t see myself going 100% in stocks after that. I also see bonds as providing some smoothening of volatility instead of just a means to get yield. Also, what about capital gains from holding bonds? If the stock market plunges 30% in the next year, and the bonds go up by 10-15%, doesn’t that provide some capital gains, additional ballast in bad times, and lets you rebalance some of it into stocks at the opportune time?

Also, the means of managing it appears a bit complex to me. Let’s say my allocation is 80% stocks and 20% bonds. Would I take this 20% bond allocation I currently have and use it for mortgage interest, and do so for all future investments? Currently, I have automatic investments in my 401k, Roth IRAs and also HSA (which I use for investing purposes only). I would have to decide how much of money I’m investing, and decide how much I would have allocated to bonds per my asset allocation and use that money for mortgage accordingly. It’s easy for me to see how much is in bonds and if it goes out of certain range, I rebalance it. But since the bond money disappeared into paying mortgage, I have a hard time thinking how I would calculate these percentages for any rebalancing between stock and bond allocations.

Another thought is on the glide path. If I use the normal glide path, I would be buying bonds and slowly building up a bond allocation. But if I use this method, and let’s say I finish my mortgage payments when I am 60, would I suddenly switch from 100% stocks to a 65/35 allocation. Are there risks to it like the bond yields being really low during this switch? Would there be a glide path inside this glide path then? Does all of this make investing complex than it needs to be?

May be I’m overthinking this, but some thoughts.

Annie
Annie
1 year ago

Jonathan – I have been following you for a few months now and I am so appreciative of all the content you put out there. This topic specifically has been on my radar and it’s been something I’ve read about thoroughly on The Bogleheads forum. It seems the discussion there often pertains to folks who are filling all tax advantaged space first or they speak as though you can make one lump sum from your bond allocation to pay off the mortgage. Neither situation is applicable to me, unfortunately. Can you help me better understand the #s as they pertain to this situation: We put 6% into trad 401K to get the 6% company match and also partially fund Roth IRAs and an HSA. 27 yrs remaining on 30 yr mortgage at 3.375%, $267k remaining balance. 22% Fed tax, 4.63% state tax, MFJ. 85/15 stock/bond. Is it wise to take essentially the exact dollar amount of the 15% bond allocation and put that into the principle of the mortgage as opposed to a bond index fund at least while the current tax code is in effect? (NOTE: We would not contribute less than the 6% to the 401k. Money would come from the IRAs and/or HSA.) Is it unwise to pay tax now on this money rather than to delay tax by filling the 401k first?

Jonathan Clements
Jonathan Clements
1 year ago
Reply to  Annie

You should always fund the 401(k) with the match. That’s an easy one. Funding the HSA should probably come next — tax-deductible on the way in, tax-free on the way out if used for medical expenses — though I might argue differently if it’s an HSA with unattractive investment options. But if you’re claiming the standard deduction, I’d be inclined to pay down the mortgage rather than buy bonds in the Roth, because the yield on high-quality bonds is less than the interest rate on your mortgage. What if you itemize and can deduct substantial amounts of mortgage interest, both at the federal and state level? If your itemized deductions are well above your standard deduction, the after-tax cost of your mortgage would be some 2 1/2%. Today, you could do slightly better in corporate bonds, though you’d also be taking somewhat more risk.

doug
doug
1 year ago

I agree with all the points except Option 3 number 4. I’m in that situation with twelve months remaining on my 4% mortgage and paying paying only $40 a month in interest and the rest principle. I don’t see the advantage of paying it off early. I’m considering a high interest savings account paying 2.36% and waiting for an opportune time to add to my diversified portfolio.

medhat
medhat
1 year ago

Jonathan, while you mention it’s not the focus of the article, is it your contention that, in most cases, if the alternative to paying down a mortgage is investment in equities (stocks), then that’s the way to go (financially)? I’m unexpectedly in that position, and that has been my approach, taking into consideration (yes) the mortgage interest tax deduction slightly benefiting an already relatively low mortgage rate, and a long-term outlook on my investment (of the amount comparable to the interest payments). As I have explained it to my broker (I usually do this myself, but in this particular case I have delegated this job), I view it as a reverse version of “dollar cost averaging”. My funds for the mortgage sit in equity investments, and monthly the amount necessary to cover the mortgage payment is sold and used to make the payment. Obviously, sometimes the market is better than other times, but it keeps the assets in stocks as long as possible, and in this case the sale is of long-term capital gains, so I make the most of that situation as well.

Jonathan Clements
Jonathan Clements
1 year ago
Reply to  medhat

When I refer to owning stocks instead of paying down the mortgage, I was thinking about owning stocks for the long haul — and not regularly cashing out a stock portfolio to cover the mortgage payment, which is what it sounds like you do. That could be an okay strategy, if the monthly sale is tiny relative to the total stock portfolio and hence you could still make the mortgage payment even if we had a five- or 10-year period of horrible stock returns. But if the monthly sale is significant relative to the stock portfolio’s size, it sounds risky.

BillyCKid
BillyCKid
1 year ago

Why does the author ignore the existance of tax-exempt municipal bonds?

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