Invest vs. Reduce Debt

SUPPOSE YOU HAVE $200,000 in bonds—and you also have $200,000 in mortgage and other debt. You should think of those debts as “negative bonds” and subtract them from your bond position. Result: In this example, your net bond position is zero. After all, while your bonds are paying you interest, your debts are costing you interest. In fact, the interest rate charged on your debts is likely greater than the interest you are earning on your bonds.

The implication: Instead of buying more bonds, you might use your extra savings to pay down debt. You may even find that, because your debts are costing you more than your bonds are earning, it makes sense to sell your bonds and use the proceeds to reduce debt.

What if we’re talking about mortgage debt, with its potentially tax-deductible interest? Let’s say you have a 5% mortgage. If you claim the standard deduction on your tax return, the mortgage is costing you the full 5%. What if you’re in the 22% federal income tax bracket and you itemize your deductions? The after-tax cost of your mortgage is just 3.9%—though the true cost could be somewhat higher, if your itemized deductions are barely higher than your standard deduction.

Fingers crossed, you should be able to earn more than that over the long term by purchasing a diversified collection of stocks. What if the alternative is to buy bonds? Suppose you can buy bonds that yield 4%, which is higher than the 3.9% after-tax cost of your mortgage. That might seem more attractive. But if the 4% bonds pay taxable interest and you hold them in a regular taxable account, you might be left with just 3.12% after paying taxes—which means paying down the mortgage will give you a better return. Even if you hold the bonds in a retirement account, you’ll eventually owe taxes, unless it’s a Roth account. The upshot: Paying down debt, even mortgage debt, is often a better deal than buying bonds.

Our Humble Opinion: Even if the potential gain from investing is higher, there’s still great virtue in paying down debt, even low-cost, tax-deductible mortgage debt. The return is guaranteed, it makes your overall finances less risky and ridding yourself of all debt is a crucial step on the journey to a comfortable retirement. Not sure whether it’s a good time to buy stocks or bonds? When in doubt, you can do a lot worse than pay down debt.

Next: Struggling With Debt

Previous: Buy vs. Lease

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