Investing vs. Payoff Mortgage

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SJR
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Investing vs. Payoff Mortgage

Post by SJR » Fri Jun 24, 2016 3:01 pm

About a year ago, I began my journey from having a managed account with a hefty fee to the 3 fund solution. After accomplishing that,I bought a house and had my first child. I am once again saving at a decent clip and am at the point where I need to decide if I I would like to invest the money "short term" (5-10 years or so) or stockpile it to pay off my mortgage.

Age: 27
Location: NY
Tax Filing Status: Married filing jointly
Current Allocation: 80% Equity, 20% bonds (retirement)

I am currently maxing out retirement (including doing both a backdoor Roth for myself and my wife) and have more than a full year's savings (I am in a volatile industry and have my own company). My mortgage rate is 4.125% over 30 years. With increasing expenses expected (growing child, and perhaps more to come) I anticipate it taking 3 years or so to save enough to pay it off entirely.

I know that there isn't any clear answer on whether to keep a mortgage and invest instead, or to pay it off. Some prefer one over the other. I guess I am looking to get some opinions, and other's thoughts based on the information that I shared.

Some other questions:
If I were to decide to pay it off, what should I do with the pile of money until I am ready to pay it off? Should I bother making large principal payments before I have enough to pay it all? My impression is that I shouldn't as until its paid off completely, all a principal payment will do is reduce the amounts of payments owed and my liquidity will be diminished with no immediate benefit (will still be paying regular monthly payments)

If I were to invest it for 5-10 years. What would the proper allocation be for this time frame? My children will all be attending private school and that is the largest expense I anticipate other than standard living expenses. It is for that reason that I am estimating withdrawals to begin in 5-10 years.

Thanks for reading this and hopefully for your opinions and help.

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Re: Investing vs. Payoff Mortgage

Post by qwertyjazz » Fri Jun 24, 2016 3:13 pm

You sound like the opposite of me. High variance income and fixed expenses which will increase in the next 5 years. The biggest short term risk in expenses greater than your 1 year savings without the ability/willingness to take equity back out of your house if you prepay. You might want to run likely scenarios over the next 10 years or do of your income stream to see how it would impact your decisions. You may want low risk investments until you reach a preset safety number.

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Re: Investing vs. Payoff Mortgage

Post by grabiner » Fri Jun 24, 2016 9:12 pm

See Paying down loans versus investing on the wiki.

Since you can afford to make extra payments, and your mortgage is at somewhat above the market rate, you might want to refinance to 15 years; this will reduce the interest payments.

However, if you plan to pay off the mortgage in three years, refinancing may not be worth the closing costs; reducing the rate from 4.125% to 2.75% for a mortgage paid off in three years saves you about 2% of the balance in interest, and that is tax-deductible. (If you do refinance, do a refinance with minimum points.)

And at current rates, paying off the mortgage, even at 15 years, may be a good deal. You didn't give your tax bracket, but if you are in the 28% federal and 6.65% NY tax bracket, then paying off a 2.75% mortgage is a 1.85% risk-free return; it's 1.75% if you are in the 33% bracket and lose 25% of your NY itemized deductions to the phase-out. The current yield on Admiral shares of Vanguard NY Long-Term Tax-Exempt, which have about the same duration as the mortgage, is 1.61%.

If you don't refinance and plan to pay the mortgage off, it's probably best to put the extra money towards the mortgage; it earns a significantly better risk-free return.

But if you do refinance and plan to pay the mortgage off, it's better to invest the money for the planned payoff in NY Long-Term Tax-Exempt. As the calculation above shows, it's close to break-even. Meanwhile, you keep your liquidity, and you can decide in three years whether you actually want to pay off the mortgage at that time. If it happens that your mortgage rate is 1.85% after tax and NY Long-Term Tax-Exempt is now yielding 2.5%, then you have a good reason not to pay it off, as you earn more by keeping the money invested at low risk.
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Re: Investing vs. Payoff Mortgage

Post by Lafder » Fri Jun 24, 2016 11:18 pm

You have more than a year's worth of savings in cash.

You can pay off your mortgage in 3 years.

You are maxing his and her retirement accounts.

I think that I would go ahead and pay off the mortgage with your extra cash flow. Then when paid off, invest the current cash that was going to your mortgage in your taxable investments.

You are already invested in the market with your current retirement accounts. I would go for the diversity of paying off the mortgage.

Admittedly I am biased by wanting mine paid off.

Once the house is paid off, hopefully the payments will be able to cover kid's private schools with incoming income that is no longer going to mortgage.

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Re: Investing vs. Payoff Mortgage

Post by grabiner » Sat Jun 25, 2016 2:39 pm

Lafder wrote:You are already invested in the market with your current retirement accounts. I would go for the diversity of paying off the mortgage.
This is a good example of the "mortgage is a negative bond" argument. Buying a bond and making a mortgage payment have the same effect on your finances, so there isn't any extra diversification benefit for paying down the mortgage rather than buying bonds.

That is why I recommend that, if you refinance the mortgage and plan to pay it off, you keep the money in a municipal-bond fund until you are ready to make the payoff. The returns on the two options are about the same, and you retain the option to not pay off the mortgage if rates rise before you are ready. In contrast, if you pay off 2/3 of the mortgage and rates rise, you may now have a 2.75% 5-year mortgage which isn't worth paying off because you can earn more than that on bonds, and you would like to take back the older years which you had already paid off.
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Re: Investing vs. Payoff Mortgage

Post by SJR » Sun Jun 26, 2016 5:00 pm

I wanted to thank everyone for responding to my question. It really means a lot. Someone actually even PM'ed me some great advice.
grabiner wrote:See Paying down loans versus investing on the wiki.

Since you can afford to make extra payments, and your mortgage is at somewhat above the market rate, you might want to refinance to 15 years; this will reduce the interest payments.
After reading "Paying down loans versus investing" in the wiki, and speaking with a local mortgage broker, I think refinancing to a 15 year is my best option. The rates are extremely low in comparison (I was told it can be as low as 2.625%), and I can take the opportunity to reduce the borrowed amount with (some) of my extra savings, thus offsetting the increased payments due to the 15 year term.
grabiner wrote:However, if you plan to pay off the mortgage in three years, refinancing may not be worth the closing costs; reducing the rate from 4.125% to 2.75% for a mortgage paid off in three years saves you about 2% of the balance in interest, and that is tax-deductible. (If you do refinance, do a refinance with minimum points.)
I would still like to pay it down sooner rather than later, but with the above (re)direction I would not be actively trying to pay it off completely within 3 years, unless my income continues to increase at a substantially faster clip than my expenses. The knowledge that the term is shorter and that I am saving considerable amount of money with less interest across the board, is sufficient for me. Instead I would perhaps begin to invest for 5-10 years from now with any extra savings and reassess a few years down the road.
grabiner wrote:And at current rates, paying off the mortgage, even at 15 years, may be a good deal. You didn't give your tax bracket, but if you are in the 28% federal and 6.65% NY tax bracket, then paying off a 2.75% mortgage is a 1.85% risk-free return; it's 1.75% if you are in the 33% bracket and lose 25% of your NY itemized deductions to the phase-out. The current yield on Admiral shares of Vanguard NY Long-Term Tax-Exempt, which have about the same duration as the mortgage, is 1.61%.


I am in the 33% tax bracket. I agree it is a good deal in the current market and that was small part of the reason that I wanted to do it. However, that itself was not enough of a reason as I believe over 30 years I should be able to do better than that with alternative (riskier) investments.
grabiner wrote:But if you do refinance and plan to pay the mortgage off, it's better to invest the money for the planned payoff in NY Long-Term Tax-Exempt. As the calculation above shows, it's close to break-even. Meanwhile, you keep your liquidity, and you can decide in three years whether you actually want to pay off the mortgage at that time. If it happens that your mortgage rate is 1.85% after tax and NY Long-Term Tax-Exempt is now yielding 2.5%, then you have a good reason not to pay it off, as you earn more by keeping the money invested at low risk.

grabiner wrote:That is why I recommend that, if you refinance the mortgage and plan to pay it off, you keep the money in a municipal-bond fund until you are ready to make the payoff. The returns on the two options are about the same, and you retain the option to not pay off the mortgage if rates rise before you are ready. In contrast, if you pay off 2/3 of the mortgage and rates rise, you may now have a 2.75% 5-year mortgage which isn't worth paying off because you can earn more than that on bonds, and you would like to take back the older years which you had already paid off.


I am confused. Above you mentioned that it does not pay to refinance to a 15 year and still pay it off within 3 years due to the closing costs which would certainly be more than 2% of the total interest owed on my current loan.

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Re: Investing vs. Payoff Mortgage

Post by grabiner » Sun Jun 26, 2016 5:24 pm

smokey joe robinson wrote:I wanted to thank everyone for responding to my question. It really means a lot. Someone actually even PM'ed me some great advice.
grabiner wrote:See Paying down loans versus investing on the wiki.

Since you can afford to make extra payments, and your mortgage is at somewhat above the market rate, you might want to refinance to 15 years; this will reduce the interest payments.
After reading "Paying down loans versus investing" in the wiki, and speaking with a local mortgage broker, I think refinancing to a 15 year is my best option. The rates are extremely low in comparison (I was told it can be as low as 2.625%), and I can take the opportunity to reduce the borrowed amount with (some) of my extra savings, thus offsetting the increased payments due to the 15 year term.
2.625% is only 1.67% after tax in your tax bracket.
grabiner wrote:And at current rates, paying off the mortgage, even at 15 years, may be a good deal. You didn't give your tax bracket, but if you are in the 28% federal and 6.65% NY tax bracket, then paying off a 2.75% mortgage is a 1.85% risk-free return; it's 1.75% if you are in the 33% bracket and lose 25% of your NY itemized deductions to the phase-out. The current yield on Admiral shares of Vanguard NY Long-Term Tax-Exempt, which have about the same duration as the mortgage, is 1.61%.


I am in the 33% tax bracket. I agree it is a good deal in the current market and that was small part of the reason that I wanted to do it. However, that itself was not enough of a reason as I believe over 30 years I should be able to do better than that with alternative (riskier) investments.
You can do that whether you pay off the mortgage or not; this is why I use a bond fund for comparison. You can increase your potential returns by keeping a mortgage and investing in stock, or by paying off the mortgage and moving bonds to stock in your investment accounts.

And given these numbers, paying down the refinanced mortgage is only break-even.
grabiner wrote:But if you do refinance and plan to pay the mortgage off, it's better to invest the money for the planned payoff in NY Long-Term Tax-Exempt. As the calculation above shows, it's close to break-even. Meanwhile, you keep your liquidity, and you can decide in three years whether you actually want to pay off the mortgage at that time. If it happens that your mortgage rate is 1.85% after tax and NY Long-Term Tax-Exempt is now yielding 2.5%, then you have a good reason not to pay it off, as you earn more by keeping the money invested at low risk.

grabiner wrote:That is why I recommend that, if you refinance the mortgage and plan to pay it off, you keep the money in a municipal-bond fund until you are ready to make the payoff. The returns on the two options are about the same, and you retain the option to not pay off the mortgage if rates rise before you are ready. In contrast, if you pay off 2/3 of the mortgage and rates rise, you may now have a 2.75% 5-year mortgage which isn't worth paying off because you can earn more than that on bonds, and you would like to take back the older years which you had already paid off.


I am confused. Above you mentioned that it does not pay to refinance to a 15 year and still pay it off within 3 years due to the closing costs which would certainly be more than 2% of the total interest owed on my current loan.
The closing costs would have to be more than 2% of the refinanced principal, not the interest, to make refinancing only break-even if you pay off the refinanced loan gradually over three years. You are saving 1.5% annually in interest by refinancing. If you pay off 1/36 of the loan every month for 36 months, you save 1.5% on an average of half the original amount over three years, which is 2.25% of the loan amount. If you pay nothing extra until you are ready to pay off the whole loan, you save 1.5% on almost the full principal, which is almost 4.5% of the loan amount.

So what I recommend is that you refinance to a 15-year loan, invest the money (and use NY Long-Term Tax-Exempt from some of your bond investments), and see what happens in three years. If interest rates don't change, you'll come out slightly ahead by paying off the mortgage with your bond investments, and you won't have lost anything by waiting three years. If interest rates rise, you'll then decide that it doesn't make sense to pay off the mortgage.

Alternatively, you could invest your taxable account in stocks, but then you have the additional issue of capital gains; you might decide in three years that it is worthwhile to pay off your mortgage at the current interest rate, but have a huge tax bill if you sold stock to do it.
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Re: Investing vs. Payoff Mortgage

Post by SJR » Sun Jun 26, 2016 8:40 pm

grabiner wrote:But if you do refinance and plan to pay the mortgage off, it's better to invest the money for the planned payoff in NY Long-Term Tax-Exempt. As the calculation above shows, it's close to break-even. Meanwhile, you keep your liquidity, and you can decide in three years whether you actually want to pay off the mortgage at that time. If it happens that your mortgage rate is 1.85% after tax and NY Long-Term Tax-Exempt is now yielding 2.5%, then you have a good reason not to pay it off, as you earn more by keeping the money invested at low risk.

grabiner wrote:That is why I recommend that, if you refinance the mortgage and plan to pay it off, you keep the money in a municipal-bond fund until you are ready to make the payoff. The returns on the two options are about the same, and you retain the option to not pay off the mortgage if rates rise before you are ready. In contrast, if you pay off 2/3 of the mortgage and rates rise, you may now have a 2.75% 5-year mortgage which isn't worth paying off because you can earn more than that on bonds, and you would like to take back the older years which you had already paid off.

I am confused. Above you mentioned that it does not pay to refinance to a 15 year and still pay it off within 3 years due to the closing costs which would certainly be more than 2% of the total interest owed on my current loan.
grabiner wrote:
The closing costs would have to be more than 2% of the refinanced principal, not the interest, to make refinancing only break-even if you pay off the refinanced loan gradually over three years. You are saving 1.5% annually in interest by refinancing. If you pay off 1/36 of the loan every month for 36 months, you save 1.5% on an average of half the original amount over three years, which is 2.25% of the loan amount. If you pay nothing extra until you are ready to pay off the whole loan, you save 1.5% on almost the full principal, which is almost 4.5% of the loan amount.

So what I recommend is that you refinance to a 15-year loan, invest the money (and use NY Long-Term Tax-Exempt from some of your bond investments), and see what happens in three years. If interest rates don't change, you'll come out slightly ahead by paying off the mortgage with your bond investments, and you won't have lost anything by waiting three years. If interest rates rise, you'll then decide that it doesn't make sense to pay off the mortgage.

Alternatively, you could invest your taxable account in stocks, but then you have the additional issue of capital gains; you might decide in three years that it is worthwhile to pay off your mortgage at the current interest rate, but have a huge tax bill if you sold stock to do it.
Yes, my mistake. I meant to write principal not interest. The closing costs I was told are between 3-4% of the refinanced principal. That's part of the reason I was thinking of using the additional savings to reduce said principal (lower closing+lower monthly payments).

Of course, over the next few years I can still invest new savings into NY Long-Term Tax-Exempt regardless and see if I want to pay it off. However, it would seem to me that with 3-4% in closing costs it may not make sense for me to go into this with that mindset of trying to pay it off so soon.

I didn't understand the first paragraph of your response so perhaps I am not thinking this through properly.

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Re: Investing vs. Payoff Mortgage

Post by grabiner » Sun Jun 26, 2016 9:47 pm

Based on all the information you have given, I believe the best strategy is to refinance to 15 years, and then invest in NY Long-Term Tax-Exempt if that is appropriate for your investment needs. It is likely that you will decide not to pay off the mortgage when you finally have enough money to do it, because interest rates may rise. Therefore, you will probably get the full benefit of the refinance.

However, I do recommend refinancing with as few points as possible, since there is a higher-than-normal chance you will pay off the mortgage early.
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Re: Investing vs. Payoff Mortgage

Post by Watty » Sun Jun 26, 2016 10:02 pm

smokey joe robinson wrote:If I were to decide to pay it off, what should I do with the pile of money until I am ready to pay it off? Should I bother making large principal payments before I have enough to pay it all? My impression is that I shouldn't as until its paid off completely, all a principal payment will do is reduce the amounts of payments owed and my liquidity will be diminished with no immediate benefit (will still be paying regular monthly payments)
One thing to look into is if your lender will "recast your mortgage"(google this).

They are not required to do this but they often will for a couple of hundred dollar processing fee. If you are able to recast and you pay off 25% of your mortgage then your required mortgage payment would also be reduced by 25%. The length of the loan and interest rate would stay the same which could be important if interest rates get higher and you want to keep the mortgage as long as possible. You would want to get the agreement to recast your mortgage in writing before sending them the money so that there are not any misunderstandings. Once you call them they will send you a simple form with the details if they will recast the mortgage.

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Re: Investing vs. Payoff Mortgage

Post by SJR » Mon Jun 27, 2016 9:22 am

grabiner wrote:Based on all the information you have given, I believe the best strategy is to refinance to 15 years, and then invest in NY Long-Term Tax-Exempt if that is appropriate for your investment needs. It is likely that you will decide not to pay off the mortgage when you finally have enough money to do it, because interest rates may rise. Therefore, you will probably get the full benefit of the refinance.

However, I do recommend refinancing with as few points as possible, since there is a higher-than-normal chance you will pay off the mortgage early.
I completely agree. Based on how low 15 year rates are it may not make sense to pay it off, especially once rates rise. After some more research I am now considering a 10 year term as well which is a slightly better rate. I would reduce the loan so that my payments are the same (as they are now or would be at 15 year term- haven't decided yet). If I decided to do this then I no longer would try to pay it off early at all. This would be a "cross-breed" (so to say) of my original intentions.

One other thing- I called my bank directly and the closing costs with them were less than 2%. However the rate was higher than what the local broker told me. I will have to research it further.

With this new information, I may consider paying a limited amount of points if it results in a sufficiently reduced rate. (anticipated higher interest rates, very low existing rate, and 10 year term)

Thanks for all the help. I really appreciate it.
Watty wrote:
smokey joe robinson wrote:If I were to decide to pay it off, what should I do with the pile of money until I am ready to pay it off? Should I bother making large principal payments before I have enough to pay it all? My impression is that I shouldn't as until its paid off completely, all a principal payment will do is reduce the amounts of payments owed and my liquidity will be diminished with no immediate benefit (will still be paying regular monthly payments)
One thing to look into is if your lender will "recast your mortgage"(google this).

They are not required to do this but they often will for a couple of hundred dollar processing fee. If you are able to recast and you pay off 25% of your mortgage then your required mortgage payment would also be reduced by 25%. The length of the loan and interest rate would stay the same which could be important if interest rates get higher and you want to keep the mortgage as long as possible. You would want to get the agreement to recast your mortgage in writing before sending them the money so that there are not any misunderstandings. Once you call them they will send you a simple form with the details if they will recast the mortgage.
Thanks for that tip. Certainly good information to be aware of.

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Re: Investing vs. Payoff Mortgage

Post by SJR » Tue Jun 28, 2016 9:21 pm

grabiner wrote:Based on all the information you have given, I believe the best strategy is to refinance to 15 years, and then invest in NY Long-Term Tax-Exempt if that is appropriate for your investment needs. It is likely that you will decide not to pay off the mortgage when you finally have enough money to do it, because interest rates may rise. Therefore, you will probably get the full benefit of the refinance.

However, I do recommend refinancing with as few points as possible, since there is a higher-than-normal chance you will pay off the mortgage early.
Latest update:

I ended up applying through the bank that currently holds my note as the local broker informed me that it would likely be more expensive through him after assignment fees etc. I locked a rate of 2.875% today on a 15 year term. I have the option of paying 5/8s of a point for a rate of 2.75%. Additionally, I was told that I can change the loan amount once (on the application I just put in my existing amount as I haven't decided if I wanted to reduce the loan to make the payment closer to what it is now). Finally, they allow you to renegotiate the rate if it drops further in the coming weeks. However, if you do you must close within 30 days (instead of the original 90). Closing costs are approximately 1.2-1.375% of the refinanced principal based on my calculations (he was not able to generate a good faith estimate at the time).

Correction: My federal tax bracket is 28% not 33%. (NYS is 6.65%)


Question:
1. How do I figure out the break even point (amount of payments) for a loan with points?
2. How do I figure out what my rate (2.875%) is valued at after tax deductions?
grabiner wrote: and then invest in NY Long-Term Tax-Exempt if that is appropriate for your investment needs
Unless that money is being used for "short" term payment of mortgage, I would likely be looking to invest the money for eventual use in 5-10 years from now for anticipated increased expenses (i.e. private school tuition). I'd imagine the portfolio would include a mix of bonds and stocks (haven't researched it yet). If I'm not mistaken, for the 3 fund solution a mid term bond (Vanguard Intermediate Term Tax Exempt) is generally recommended for taxable accounts. Are you recommending NY Long-Term Tax-Exempt specifically due to the state tax exemption? Is that worth the increased risk vs. a mid term fund, being that I may decide to use it within 3 years? (I agree that for the 5-10 year investment plan this fund is likely the best for me in my taxable account)

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Re: Investing vs. Payoff Mortgage

Post by grabiner » Tue Jun 28, 2016 10:34 pm

smokey joe robinson wrote:I ended up applying through the bank that currently holds my note as the local broker informed me that it would likely be more expensive through him after assignment fees etc. I locked a rate of 2.875% today on a 15 year term. I have the option of paying 5/8s of a point for a rate of 2.75%.

1. How do I figure out the break even point (amount of payments) for a loan with points?
The break-even for that is about six years. 5/8 of a point for 1/8% rate reduction would have a 5-year break-even if the balance were constant, but since the balance decreases, 1/8% of interest over six years is close to 6/8% of the original balance.
Correction: My federal tax bracket is 28% not 33%. (NYS is 6.65%)

2. How do I figure out what my rate (2.875%) is valued at after tax deductions?
2.875*(1-.0665)*(1-.28)=1.93

The reason for the multiplication is that you deduct NY tax from federal, so only 72% of the 6.65% NY tax is actually lost.
grabiner wrote: and then invest in NY Long-Term Tax-Exempt if that is appropriate for your investment needs
Unless that money is being used for "short" term payment of mortgage, I would likely be looking to invest the money for eventual use in 5-10 years from now for anticipated increased expenses (i.e. private school tuition). I'd imagine the portfolio would include a mix of bonds and stocks (haven't researched it yet). If I'm not mistaken, for the 3 fund solution a mid term bond (Vanguard Intermediate Term Tax Exempt) is generally recommended for taxable accounts. Are you recommending NY Long-Term Tax-Exempt specifically due to the state tax exemption? Is that worth the increased risk vs. a mid term fund, being that I may decide to use it within 3 years? (I agree that for the 5-10 year investment plan this fund is likely the best for me in my taxable account)
The reason I recommend NY Long-Term Tax-Exempt is not the state tax exemption, but the fact that the interest-rate risk is canceled out by the mortgage; the bond fund and the mortgage have about the same duration.

The comparison is easier to understand if you look at individual bonds. Suppose that, over the next three years, you buy a portfolio of NY municipal bonds maturing over the following 12 years, with payments equal to the amount you owe on the mortgage each year. You would have no interest-rate risk; whatever happens to interest rates, your bonds would make the mortgage payment. You might then choose to sell the bond portfolio to pay off the mortgage, this would be a good deal if the after-tax mortgage rate is higher than the bond yield.

You probably don't intend to buy that specific bond portfolio, but NY Long-Term Tax-Exempt holds a similar portfolio; its duration is 6 years, and the duration of a mortgage with 12 years left is slightly under 6 years. If interest rates rise, you will lose money on the bond fund, but the real value of the loan to the bank will also fall, so you break even; you will benefit because the bank must continue to lend you money at 1.93% after tax when you can earn 3% on your bond investments.

For general-purpose investing in NY, I would normally recommend half NY Long-Term Tax-Exempt and half Limited-Term Tax-Exempt, to get an intermediate-term duration with half your bonds in NY and more than half the interest exempt from NY tax.
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