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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.
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I would agree with this if the actual interest you paid was level over the life of the mortgage, but it isn’t. Most of what you pay in the first few years of a mortgage is interest, and little reduces your principal. In year 1 and 2, it is close to 100% interest. So I always advocate paying down your mortgage in the early years as best you can. I get beat up for that view, but I don’t think the tax benefit (and until recently at least) inflation offset the benefits you get over time by having faster growth of principal (your real home asset) later over the life of your mortgage.
You may pay less interest in dollar terms later in the life of a mortgage, but that’s because you owe less money at that point. The interest rate is the same and thus the analysis doesn’t change on the decision of whether to invest or pay down debt.
Most people have a hard time understanding this simple concept. Assuming you cannot deduct the mortgage interest and you are paying state income tax on your fixed income investments, you would need a return of over 6% to equal the return on paying down a 5% mortgage. If people want stability and guaranteed returns, paying down debt, including low interest mortgage debt, is a no-brainer.
Of course, what I hear from other people’s financial advisors and accountants is to keep the mortgage (or even get a cash out refinance) and invest in the stock market at all time highs. I was in a Zoom meeting recently with a mortgage broker whose client refinanced for $1 million so that her client could put half into stocks. I kept quiet since it wasn’t my business, but another person commented “that’s brilliant!” I was left shaking my head in dismay.