Bonds vs. paying off mortgage  comparing returns
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 pretax? So add to CD rather than prepay mortgage. Just want to make sure I’m taking tax into consideration correctly when I compare. Thanks!
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 pretax? So add to CD rather than prepay mortgage. Just want to make sure I’m taking tax into consideration correctly when I compare. Thanks!
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.
The difference is small enough that this isn’t an algebra problem. You need to decide whether you value liquidity or reduced debt.

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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.
Re: Bonds vs. paying off mortgage  comparing returns
I can fully deduct the mortgage interest though. So if I'm going to use aftertax yield for comparison, shouldn't I also reduce the rate of return from paying off mortgage early?strafe wrote: ↑Mon Sep 30, 2019 5:36 amThe 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'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 aftertax return though).
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.
Re: Bonds vs. paying off mortgage  comparing returns
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 aftertax yield of my 3.2% CD, I'd calculate 3.2% * (10.350.0930.038) (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% * (10.350.0930.038). Am I doing this wrong? Thanks!
Re: Bonds vs. paying off mortgage  comparing returns
I'd say you're doing it right, but some of the details need fixing. I ran numbers through tax software. The CD aftertax 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 aftertax 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.]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 aftertax yield of my 3.2% CD, I'd calculate 3.2% * (10.350.0930.038) (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% * (10.350.0930.038). Am I doing this wrong? Thanks!
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 marginalrate 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.
Re: Bonds vs. paying off mortgage  comparing returns
Thank you! Which tax software do you use to do this? I use TurboTax every year  something I can do with that?Klewles wrote: ↑Tue Oct 01, 2019 4:29 amI'd say you're doing it right, but some of the details need fixing. I ran numbers through tax software. The CD aftertax 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 aftertax 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.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 aftertax yield of my 3.2% CD, I'd calculate 3.2% * (10.350.0930.038) (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% * (10.350.0930.038). Am I doing this wrong? Thanks!
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 marginalrate 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.
When I am comparing bonds vs. paying off mortgage (or between munis vs. CDs, etc.), should I always focus on the aftertax return, since that's what I take home, which is what matters at the end of the day? I thought you could use either pretax or aftertax as long as you're being consistent, but I'm not sure if comparing pretax 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 aftertax yield and compare that with the aftertax mortgage yield. Thanks!
Re: Bonds vs. paying off mortgage  comparing returns
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 phaseout of CA mortgage deduction has a bigger effect than I figured, and if your AGI results in a partial phaseout, 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 aftertax 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 phaseout 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.
You can use either aftertax or pretax 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 phaseout. 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.ma21n2 wrote: ↑Tue Oct 01, 2019 2:14 pmWhen I am comparing bonds vs. paying off mortgage (or between munis vs. CDs, etc.), should I always focus on the aftertax return, since that's what I take home, which is what matters at the end of the day? I thought you could use either pretax or aftertax as long as you're being consistent, but I'm not sure if comparing pretax 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 aftertax yield and compare that with the aftertax mortgage yield. Thanks!