## Bonds vs. paying off mortgage - comparing returns

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Topic Author
ma21n2
Posts: 71
Joined: Fri Sep 28, 2018 9:25 pm

### Bonds vs. paying off mortgage - comparing returns

I’ve been reading about the topic of invest in bonds vs. pay extra towards your mortgage. I understand one factor to consider is your current mortgage rate and the yield you can get from the bonds market.

I recently refinanced into a 5/1 ARM at 2.75%. I deduct mortgage interest.

I have a Navy Federal CD that matures next year, and they let me add more money into it. It pays 3.2% I think.

In this case, can I consider the CD to be yielding more, because both percentage numbers are pre-tax? So add to CD rather than prepay mortgage. Just want to make sure I’m taking tax into consideration correctly when I compare. Thanks!

strafe
Posts: 964
Joined: Sat Mar 03, 2007 12:49 pm

### Re: Bonds vs. paying off mortgage - comparing returns

The after tax yield on the CD is less than your mortgage rate (I’m making some assumptions regarding your marginal federal and state tax rate).

The difference is small enough that this isn’t an algebra problem. You need to decide whether you value liquidity or reduced debt.

UpperNwGuy
Posts: 2632
Joined: Sun Oct 08, 2017 7:16 pm

### Re: Bonds vs. paying off mortgage - comparing returns

As long as you can get more interest on CDs than the interest you pay on your mortgage, I would keep adding to the CDs rather than making early mortgage payments.

Topic Author
ma21n2
Posts: 71
Joined: Fri Sep 28, 2018 9:25 pm

### Re: Bonds vs. paying off mortgage - comparing returns

strafe wrote:
Mon Sep 30, 2019 5:36 am
The after tax yield on the CD is less than your mortgage rate (I’m making some assumptions regarding your marginal federal and state tax rate).

The difference is small enough that this isn’t an algebra problem. You need to decide whether you value liquidity or reduced debt.
I can fully deduct the mortgage interest though. So if I'm going to use after-tax yield for comparison, shouldn't I also reduce the rate of return from paying off mortgage early?

I'm in 35% Fed + 9.3% State income tax brackets. Also subject to 3.8% Net Investment Income tax (not sure if I should take this into account when calculating mortgage after-tax return though).

Rudedog
Posts: 146
Joined: Wed Aug 01, 2018 3:15 pm

### Re: Bonds vs. paying off mortgage - comparing returns

I had the same situation last year. I decided to pay off the mortgage, the sure thing. It gives me great peace of mind to have zero debt.

nura
Posts: 147
Joined: Mon Jun 27, 2016 11:24 am

### Re: Bonds vs. paying off mortgage - comparing returns

ma21n2 wrote:
Mon Sep 30, 2019 4:46 am
I recently refinanced into a 5/1 ARM at 2.75%. I deduct mortgage interest.
Your effective deduction on mortgage is in excess of Standard Deduction, not the whole of it.

Topic Author
ma21n2
Posts: 71
Joined: Fri Sep 28, 2018 9:25 pm

### Re: Bonds vs. paying off mortgage - comparing returns

nura wrote:
Mon Sep 30, 2019 6:57 am
ma21n2 wrote:
Mon Sep 30, 2019 4:46 am
I recently refinanced into a 5/1 ARM at 2.75%. I deduct mortgage interest.
Your effective deduction on mortgage is in excess of Standard Deduction, not the whole of it.
Good point -- with the SALT cap of \$10K, effectively, I don't get to deduct the entire mortgage interest. Since standard deduction is \$12K, I can essentially deduct total mortgage interest paid minus \$2,000 (because I can itemize state income tax, which is over \$10K/year).

But when I'm comparing the yield of buying bonds vs. paying off mortgage early, shouldn't I be using the marginal tax deduction benefit, similar to the way we use marginal tax rate when we do this sort of comparison (as opposed to effective tax rate)? For example, to calculate after-tax yield of my 3.2% CD, I'd calculate 3.2% * (1-0.35-0.093-0.038) (i.e., I use 35% federal tax rate, even though my effective federal tax rate is much lower than that). For mortgage, if I'm paying \$10,000/yr in interest now (so I'd itemize \$20K, which is only \$8K above standard deduction) and I decide to pay off mortgage early such that I'd only pay \$8,000/yr, I'd still consider this to be equivalent to yielding only 2.75% * (1-0.35-0.093-0.038). Am I doing this wrong? Thanks!

Klewles
Posts: 28
Joined: Thu Sep 05, 2019 3:37 am

### Re: Bonds vs. paying off mortgage - comparing returns

ma21n2 wrote:
But when I'm comparing the yield of buying bonds vs. paying off mortgage early, shouldn't I be using the marginal tax deduction benefit, similar to the way we use marginal tax rate when we do this sort of comparison (as opposed to effective tax rate)? For example, to calculate after-tax yield of my 3.2% CD, I'd calculate 3.2% * (1-0.35-0.093-0.038) (i.e., I use 35% federal tax rate, even though my effective federal tax rate is much lower than that). For mortgage, if I'm paying \$10,000/yr in interest now (so I'd itemize \$20K, which is only \$8K above standard deduction) and I decide to pay off mortgage early such that I'd only pay \$8,000/yr, I'd still consider this to be equivalent to yielding only 2.75% * (1-0.35-0.093-0.038). Am I doing this wrong? Thanks!
I'd say you're doing it right, but some of the details need fixing. I ran numbers through tax software. The CD after-tax yield is what you describe: 3.2% * (1 - 0.35 - 0.038 - 0.093) = 1.66%. The mortgage yield is trickier. First, mortgage deduction does not figure into the Net Investment Income tax (it's based on AGI). Second, since you're in the 35% federal bracket, you probably have enough AGI to partially phase out the CA mortgage deduction. That means your after-tax mortgage yield is somewhere between 2.75% * (1 - 0.35) = 1.79% and 2.75% * (1 - 0.35 - 0.093) = 1.53%, depending on your total AGI. [Oops, see correction in my message below.]

So whether the CD is better or paying the mortgage is better depends on your AGI. But the yields are so close you could decide based on preference.

BTW, I find it useful to verify marginal-rate analysis using tax software. There are plenty of gotchas in the tax code. I often find that marginal rate is not what I thought it'd be.
Last edited by Klewles on Wed Oct 02, 2019 1:20 am, edited 1 time in total.

Topic Author
ma21n2
Posts: 71
Joined: Fri Sep 28, 2018 9:25 pm

### Re: Bonds vs. paying off mortgage - comparing returns

Klewles wrote:
Tue Oct 01, 2019 4:29 am
ma21n2 wrote:
But when I'm comparing the yield of buying bonds vs. paying off mortgage early, shouldn't I be using the marginal tax deduction benefit, similar to the way we use marginal tax rate when we do this sort of comparison (as opposed to effective tax rate)? For example, to calculate after-tax yield of my 3.2% CD, I'd calculate 3.2% * (1-0.35-0.093-0.038) (i.e., I use 35% federal tax rate, even though my effective federal tax rate is much lower than that). For mortgage, if I'm paying \$10,000/yr in interest now (so I'd itemize \$20K, which is only \$8K above standard deduction) and I decide to pay off mortgage early such that I'd only pay \$8,000/yr, I'd still consider this to be equivalent to yielding only 2.75% * (1-0.35-0.093-0.038). Am I doing this wrong? Thanks!
I'd say you're doing it right, but some of the details need fixing. I ran numbers through tax software. The CD after-tax yield is what you describe: 3.2% * (1 - 0.35 - 0.038 - 0.093) = 1.66%. The mortgage yield is trickier. First, mortgage deduction does not figure into the Net Investment Income tax (it's based on AGI). Second, since you're in the 35% federal bracket, you probably have enough AGI to partially phase out the CA mortgage deduction. That means your after-tax mortgage yield is somewhere between 2.75% * (1 - 0.35) = 1.79% and 2.75% * (1 - 0.35 - 0.093) = 1.53%, depending on your total AGI.

So whether the CD is better or paying the mortgage is better depends on your AGI. But the yields are so close you could decide based on preference.

BTW, I find it useful to verify marginal-rate analysis using tax software. There are plenty of gotchas in the tax code. I often find that marginal rate is not what I thought it'd be.
Thank you! Which tax software do you use to do this? I use TurboTax every year -- something I can do with that?

When I am comparing bonds vs. paying off mortgage (or between munis vs. CDs, etc.), should I always focus on the after-tax return, since that's what I take home, which is what matters at the end of the day? I thought you could use either pre-tax or after-tax as long as you're being consistent, but I'm not sure if comparing pre-tax returns makes sense. So for example, if I invest in munis like VCAIX (rather than the 3.2% CD), I'd just take the yield of VCAIX as after-tax yield and compare that with the after-tax mortgage yield. Thanks!

Klewles
Posts: 28
Joined: Thu Sep 05, 2019 3:37 am

### Re: Bonds vs. paying off mortgage - comparing returns

ma21n2 wrote:
Tue Oct 01, 2019 2:14 pm
Thank you! Which tax software do you use to do this? I use TurboTax every year -- something I can do with that?
I use Taxact, but Turbotax is just as good. The desktop versions allow you to play "what if" by creating returns for test cases. Can't do that with online versions (I don't think).

What I said above about marginal rates is not quite correct. The phase-out of CA mortgage deduction has a bigger effect than I figured, and if your AGI results in a partial phase-out, then paying off the mortgage is probably better. Here's an example from the tax software:

Case 1) \$280,000 taxable interest, \$10K mortgage interest, \$10K CA tax deduction: tax due is \$69,730 Fed, \$22,841 CA.

Case 2) \$277,673 taxable interest, \$8K mortgage interest, \$10K CA tax deduction: tax due is \$69,527 Fed, \$22,668 CA.

Case 2 diverts \$72,727 from CD to mortgage; that lowers CD interest by 3.2% * 72727 = \$2,327 and mortgage interest by 2.75% * 72727 = \$2000; and it lowers tax bill by \$376, an after-tax boost in yield of 376 / 72727 = 0.52%. Drilling down on the two returns, the expected tax rates are observed (35% Fed, 3.8% NIT, 9.3% CA). But the phase-out of the CA mortgage deduction is the unexpected twist.

So in this example paying down the mortgage is better. But your mileage may vary, depending on AGI. Hard to know in advance which is better.
ma21n2 wrote:
Tue Oct 01, 2019 2:14 pm
When I am comparing bonds vs. paying off mortgage (or between munis vs. CDs, etc.), should I always focus on the after-tax return, since that's what I take home, which is what matters at the end of the day? I thought you could use either pre-tax or after-tax as long as you're being consistent, but I'm not sure if comparing pre-tax returns makes sense. So for example, if I invest in munis like VCAIX (rather than the 3.2% CD), I'd just take the yield of VCAIX as after-tax yield and compare that with the after-tax mortgage yield. Thanks!
You can use either after-tax or pre-tax yield for comparison. But as this example shows, it might be hard to know in advance the correct value of either, because of gotchas like the mortgage phase-out. Nevertheless, we're all forced to make an educated guess about what the yields will be so that we can allocate accordingly. I use prior year's tax return and play some "what ifs" with the software to help make the guess.