Pay off mortgage or invest extra funds

[White.Beard.Doc]

I am trying to decide if I should pay off my mortgage or if I should invest a large amount of cash that I have on hand.  I am in my 50's but I love my work and don't plan on retiring any time soon.  More likely I will just cut back my hours as I get older.  I have saved diligently and maxed out all retirement accounts for 3 decades, so I am pretty much financially in a very strong position.

I have an outstanding mortgage on my home with a 3.125% interest rate.  My marginal federal tax bracket is 39.6% and state is 6.85%.  I am not subject to AMT but I am subject to deduction phaseouts.  I figure my total marginal tax rate is not far below the 50% mark.  So my effective mortgage interest rate after tax deductions is roughly in the range of 1.7%.  I could invest in a vanguard tax free bond fund that is exempt from both state and federal taxes.  This fund has earned 5.9% at a fairly steady rate over the decades, although in the current lower interest rate environment it is earning in the range of 4% tax free.

I understand that this bond fund carries some risk, although that risk appears reasonably limited.  I feel like I would be trading relatively low risk and make 4% tax free over the next decade if I invest in the bond fund, and pay back the mortgage at an effective interest rate of 1.7% due to the tax deduction.  What makes the most sense given my current options?

[TheGipper]

I think expecting any bond fund to give you 4% is still asking a bit much...

I am in a similar position (not with lump sum cash, but with excess monthly). I chose to put about 2/3 to mortgage principal payments and 1/3 to taxable account (mix of US & international stock index funds and municipal bonds matching my desired taxable account AA). Probably would be wiser to just put 100% towards mortgage, but in my mind it's a hedge against a very strong or very weak market in the next 5 years.

[Joseph]

How much is left on the mortgage (time and money)?  There comes a time to just pay it off.

[Zaphod]

Its not hard to get a tax effective yield of 4% at all in a bond fund (at your marginal rate in california im guessing), even an unleveraged vanguard intermediate gives you that and there are several others. My personal opinion only, but paying down 1.7% just isnt so worthwhile. If anything make a fund like yours and make the "extra mortgage payments" in that instead. If after a few years you still want to pay down the mortgage, liquidate and do so, at least you have the option. Its not a hedge against the market its an inflation hedge really. There are lots of bond funds that yield over 4%, they will be leveraged of course, but tax equivalent yield will be 7-9% (and are up ytd as well).

Lots of people feel differently of course, and if it makes sense to you and you understand the tradeoffs, fair enough.

[White.Beard.Doc]

Joseph wrote:

How much is left on the mortgage (time and money)?  There comes a time to just pay it off.

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We sold the house where we raised our children and then a few years back, in the middle of the real estate crash, we bought a new home. It is a great house for us for many reasons. It was a foreclosure that we bought from the bank and the price was too good to pass up.  We could have paid cash but we took out a big mortgage to get the maximum tax deduction. With the real estate recovery, the house has literally doubled in value and the homes in this area are now selling well.

Our mortgage balance is significant with many years to go, but at an effective interest rate after taking taxes into consideration of around 1.7%.  It seems to make more sense to keep the mortgage as long as I want to continue working and as a result pay high marginal income tax rates. But my current struggle is what to do with investing all the left over money. I have been investing some of my taxable investments with Wealthfront, in a mix of low cost index mutual funds.  And we own multiple investment real estate properties that are throwing off more and more positive cash flow now that most of those mortgages have been paid off.

So my thought is to invest in a tax free municipal bond fund with Vanguard where the effective yield is almost double because of my high marginal tax rate.  If I do the calculation, the spread between paying off the home mortgage versus earning income on the bond fund is about 25k of tax free income per year, or the equivalent of 50k of taxable income per year.

As I write these numbers down and work through this, maybe I should just simplify my life and pay off the mortgage. Yes it probably makes financial sense to do the opposite, but I don't need the money at this stage of my life and simplicity may have its own intrinsic value. Sitting on too much cash in a savings account feels like a burden to do something, anything, to put the money to work. And what I really want to do is spend more time volunteering and giving back.  With all the talk in our country during this presidential election season about the rapacious 1%, it almost feels like I am being told I am guilty of too much success. I have simply been spending my days studying, working, and carefully planning and investing. And that plus some measure of good parents and good luck has led me to this place of wealth and too many choices.

[jfoxcpacfp]

Have you considered how much good you could do by maximizing your wealth? Think Bill Gates, Andrew Carnegie, John D. Rockefeller...If you're a believer, there is scriptural basis for this philosophy. Luck may not have as much to do with where you find yourself as you think.

[AlexxT]

Decide where you will get the best return and invest it.  You don't have to buy bonds,  You can buy index funds, especially now that the market is down.  Since you like real estate ( I don't ) you could buy another investment property.

That said, I decided to pay off my remaining 3% mortgage ( about 200k)  rather than invest the money, because I have all my money in index funds and no bonds.  I concluded that paying off the mortgage would be my bond-equivalent.  It also feels good to have no debt and it simplified my financial calculations.  I have a line of credit I can use if I need a lot of cash on short notice.

[TheGipper]

I guess bottom line is since none of can time the market, we can never know except in retrospect if it was wiser to pay down mortgage/debt or invest in these cases. As long as you're maximizing the % of your money to productive ends such as these, you've already succeeded no matter which you choose.

[Zaphod]

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TheGipper wrote:

I guess bottom line is since none of can time the market, we can never know except in retrospect if it was wiser to pay down mortgage/debt or invest in these cases. As long as you’re maximizing the % of your money to productive ends such as these, you’ve already succeeded no matter which you choose.

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What does timing the market have to do with anything? Also, this wisdom also applies to the house since timing of selling if ever, is also a market timing event and its ultimate sell price is unknowable (except the transaction fee will be exorbitant). Its straightforward and dead simple math to know when your getting a better return or not. The simplified version is to look at safe  competing yields. Here:

Inflation (2015): 0.7%

Tax effective mortgage rate: 1.7%, 1% real.

10y yield: 1.85%, 1.15% real

30y yield: 2.68%, 1.98% real

5 y CD (first result on google): 2.0%, 1.3% real.

You most certainly can and now do know what gives you the better return. No one has to do anything, its their money, but its absolutely not true that you either have to time the market or cannot get a better or in fact much much safer return on your money. Real return on paying down the mortgage is about 1%. Current real return on the 10 year is higher than that and is much safer than your mortgage, with minimal transaction costs/slippage.

Again, as is done so often on these finance forums, student loans (except for one time capitalization) and mortgages are simple interest, investing in an index fund in compound interest. You cannot put a 2% simple interest against a 2% compound interest and call them equivalent since they are not. For example.

Simple: 100 principal, 2% interest: you get 2 dollars a year, every year.

Compound: same princ/intrst: 2 in first year which is added to prinicpal which interest now applies to, 2.04 second, and so on, making a huge difference over long periods of time.

Everyone has to do what they feel most comfortable with, etc...but lets not just throw empty platitudes around when these things are indeed knowable, and really simple. No one has to agree with anyone elses approach, but we should all recognize certain base realities.

[Zaphod]

AlexxT wrote:

Decide where you will get the best return and invest it.  You don’t have to buy bonds,  You can buy index funds, especially now that the market is down.  Since you like real estate ( I don’t ) you could buy another investment property.

That said, I decided to pay off my remaining 3% mortgage ( about 200k)  rather than invest the money, because I have all my money in index funds and no bonds.  I concluded that paying off the mortgage would be my bond-equivalent.  It also feels good to have no debt and it simplified my financial calculations.  I have a line of credit I can use if I need a lot of cash on short notice.

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Why are you thinking about your mortgage as a bond replacement? Do you simply mean as a means of overall diversification against your stock heavy portfolio?

[White.Beard.Doc]

Zaphod wrote:

Inflation (2015): 0.7% Tax effective mortgage rate: 1.7%, 1% real. 10y yield: 1.85%, 1.15% real 30y yield: 2.68%, 1.98% real 5 y CD (first result on google): 2.0%, 1.3% real.

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As far as the estimated rates that you listed, it looks like you considered the tax savings to calculate the effective mortgage rate (3.125% mortgage interest rate before considering taxes, 1.7% after taxes, and 1% after taking into account current inflation).

 

However, on the earnings on investment side of the calculation, you considered the actual yield and then yield after considering inflation.  But wouldn't these yields be taxable, meaning I would have to cut the yield in half (the amount of earnings I can hold onto after paying taxes) and only then take inflation into consideration?

 

The reason that I have been considering the vanguard tax free bond fund for money that would otherwise go towards paying off my mortgage is for 2 reasons.  It is relatively low risk in comparison with a stock fund in terms of short term risk of loss of principal (however, if we do get into a big rising interest rate trend over the next few years, the overall yield and principal value could potentially go down somewhat). And the 4% yield on the tax free municipal bonds that would most likely be earned over a period of years is tax free.  That would be the equivalent of earning almost 8% in a taxable account.

 

In any case, yesterday I decided to at least try to overcome the inertia of all that money sitting in my savings account.  (i have already been maxing out on retirement accounts for decades, but here I am talking about my taxable funds.)  I invested about 15% of my cash savings that is separate from my emergency cash fund.  I bought a chunk of the Vanguard Tax Free Municipal Bond Fund for my state.  I bought some Wealthfront balanced portfolio of index mutual funds.  And I am still thinking maybe I should pay down my mortgage to a degree.  A little bit of everything, but at least it was a start.  A balanced approach?  Time will tell.

 

Don't just sit there, do something...  Sometimes we have that same issue in medicine.  The nurse is standing there looking at you, "Well doctor, what are we going to do here?" And sometimes it is the right decision to do something, and sometimes not.  Again, time will tell.  Just like investing.

[TheGipper]

Zaphod, what I mean is the following.

Let's say hypothetically the market will drop another 30% between now and the summer. In retrospect it would have been wiser to make a lump sum payment to mortgage today than a lump sum payment to taxable investment account.

If instead we experience a 30% bounce from now until the summer, then it would have been better to lump sum today into taxable account.

Since future market performance is generally unknowable, this usually isn't worth considering, but I wouldn't discount a strategy that tactically preferentially invests when well into a deep correction (i.e. 2009) vs pays off mortgage during a prolonged bull market (i.e. now).

[NJDoc]

Obviously this is a topic that has been discussed a lot. For what it's worth the link below goes to one of the best discussions I have ever read on mortgage payoff vs investing.

http://financialmentor.com/financial-advice/pay-off-mortgage-early-or-invest/7478

[Zaphod]

White.Beard.Doc wrote:

Zaphod wrote:

Inflation (2015): 0.7% Tax effective mortgage rate: 1.7%, 1% real. 10y yield: 1.85%, 1.15% real 30y yield: 2.68%, 1.98% real 5 y CD (first result on google): 2.0%, 1.3% real.

Click to expand…

As far as the estimated rates that you listed, it looks like you considered the tax savings to calculate the effective mortgage rate (3.125% mortgage interest rate before considering taxes, 1.7% after taxes, and 1% after taking into account current inflation).

 

However, on the earnings on investment side of the calculation, you considered the actual yield and then yield after considering inflation.  But wouldn’t these yields be taxable, meaning I would have to cut the yield in half (the amount of earnings I can hold onto after paying taxes) and only then take inflation into consideration?

 

The reason that I have been considering the vanguard tax free bond fund for money that would otherwise go towards paying off my mortgage is for 2 reasons.  It is relatively low risk in comparison with a stock fund in terms of short term risk of loss of principal (however, if we do get into a big rising interest rate trend over the next few years, the overall yield and principal value could potentially go down somewhat). And the 4% yield on the tax free municipal bonds that would most likely be earned over a period of years is tax free.  That would be the equivalent of earning almost 8% in a taxable account.

 

In any case, yesterday I decided to at least try to overcome the inertia of all that money sitting in my savings account.  (i have already been maxing out on retirement accounts for decades, but here I am talking about my taxable funds.)  I invested about 15% of my cash savings that is separate from my emergency cash fund.  I bought a chunk of the Vanguard Tax Free Municipal Bond Fund for my state.  I bought some Wealthfront balanced portfolio of index mutual funds.  And I am still thinking maybe I should pay down my mortgage to a degree.  A little bit of everything, but at least it was a start.  A balanced approach?  Time will tell.

 

Don’t just sit there, do something…  Sometimes we have that same issue in medicine.  The nurse is standing there looking at you, “Well doctor, what are we going to do here?” And sometimes it is the right decision to do something, and sometimes not.  Again, time will tell.  Just like investing.

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It would of course depend where you put the bonds (and would not be 50% for a CD), non munis usually dont go into taxable but a deferred account so thats true. Now you have to take your muni bond yield and INCREASE for the taxes you would be charged on an investment to yield the same. I myself have muni bond funds, they are far less volatile, tax free, are second only in safety to US treasuries, and even when municipalities go under they recover about 67 cents on the dollar so not a total loss. They are an excellent tool. The other thing I didnt mention was with a static mortgage payment you would be paying in more expensive uninflated dollars today, whereas spreading them out lets inflation eat at the payment in a compounded manner.

Doing a little bit of everything is an excellent idea. I chose student loan terms that gave me an accelerated payoff (compared to standard) and pay a smidgen more on my mortgage every month, nominally its tiny and the rest goes to investments but its nice to be able to do it all. Whenever I think about paying extra on things now I add to my muni bond fund and increase the monthly payout I receive. If/when I want I mentally think that I'll direct the cash from that to the debt, helps me avoid paying off into a lesser return.

But, as I said, do whatever you want, there is no wrong answer (though I like how you've started) and its your choice and in the end all good ones. Its a degree and outcomes issue. I just do grow tired of the simple/compound and other things used incorrectly to justify or even try to demonstrate the superiority of one move over the other.

[Zaphod]

TheGipper wrote:

Zaphod, what I mean is the following.

Let’s say hypothetically the market will drop another 30% between now and the summer. In retrospect it would have been wiser to make a lump sum payment to mortgage today than a lump sum payment to taxable investment account.

If instead we experience a 30% bounce from now until the summer, then it would have been better to lump sum today into taxable account.

Since future market performance is generally unknowable, this usually isn’t worth considering, but I wouldn’t discount a strategy that tactically preferentially invests when well into a deep correction (i.e. 2009) vs pays off mortgage during a prolonged bull market (i.e. now).

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No. Why are you thinking so short term? It matters zero what the market does in the next 6 months. (Also we are talking about bonds, if your scenario was true then the purchases would have appreciated greatly and been an excellent investment). What would matter is 10, 20, 30 years from now and a 30% correction over a summer will be difficult to find on the chart that almost certainly slopes up and to the right.

Lets say the OP lives in Cali and just invested in Vanguard Intermediate bond fund, from 2006-2009 bull to bottom, it lost 7.27%. It is not tracking the s/p. You could put it wherever and expose yourself to the full market, but you of course have multiple choices.

If future market performance is so unknowable and not worth considering, why would anyone put money in there ever? The truth is that while we know its foolish to predict the day to day moves, we all "know" that in the long run the market grows and goes up (at least until this point). Thats why we invest in it.

It doesnt matter when the assets were purchased when contemplating a decision to be made now. The only thing that matters is your return for this next decision to put your money at work (in pure economic terms). That will not increase the value of the allocation whatsoever.