Sunday, April 7, 2013

Got A Mortgage? ... Own Some Bonds or CDs? ... Consider Paying Off the Mortgage Early

We live in a period of historically low interest rates. As a result, the interest rate on mortgages is also at historic lows today.

On the other hand, the interest rates we receive on investments in bonds and CDs are even lower than the rates being charged on our mortgages.

So what do we do? Pay off the mortgage early, that's what.

Thus, the simple answer to what to do with a low interest rate mortgage today is to strongly consider paying off that mortgage early.

Because if we are paying 5% in interest on the mortgage and only getting 3% or perhaps closer to zero on our savings, we'll be saving lots of money by reinvesting that money and paying off the mortgage debt early.

So now let's look at the reasons why it makes sense to do so.

Pay Off That Mortgage Now! makes the common sense based case for accelerating mortgage payments as follows:

"Want to beat the Treasury market? Pay off your mortgage.

Repaying a mortgage early offers, in essence, a risk-free return in the form of the interest saved. Nowadays anyone with a mortgage of 4% or 5% can earn more by repaying the loan than by investing in bonds, which have been rallying for most of the past three decades.

Repaying a mortgage also offers flexibility. If interest rates rise, investors can stop paying extra toward a mortgage and devote that money to higher-yielding instruments. . . .

The concept of "deleveraging," or reducing debt, isn't new. Five years ago, as the economy was shrinking and the stock market was tanking, homeowners began to rethink the amount of debt they carried. Banks reported strong interest in "cash-in" mortgages, which allow people to pay down their principal and reduce their interest rates at the same time.

The problem: People who took money out of their stockholdings to pay down their mortgages missed out on some or all of the stock market's historic rally since 2009.

A better way to deleverage is to use money earmarked for bonds, not stocks, to repay a mortgage.

The strategy makes the most sense for older investors and those who are otherwise investing in low-yielding bonds. But it might work for younger investors as well.

While mortgage rates are low, bond yields are even lower. The average interest rate on an outstanding mortgage was about 4.9% at the end of last year, according to data from the Bureau of Economic Analysis. That is far higher than the 1% in annual interest investors are earning on bank deposits and money-market accounts, or the 2% they are earning on 10-year Treasurys. At those rates, investors probably won't even keep up with inflation over the long term. . . .

Recently many investors have been responding to the collapse in interest rates by taking on increasing amounts of risk, such as buying "junk" bonds issued by less-creditworthy companies. But those carry bigger risks.

Older people tend to have more money in bonds and bank deposits, so the strategy of repaying a mortgage instead of keeping it in bonds is especially good for them.

But younger investors also might want to consider repaying at least some of their mortgage using money they otherwise would invest in bonds, simply because repaying the mortgage offers a higher rate of return than that available in the bond market. If conditions change, they can always put more of that money back into bonds.

What about using money earmarked for stocks to pay down a mortgage? Even here, the case isn't all bad. Sure, the market is rallying—but that could make for lower returns in the future.

What's more, numerous studies have shown that most investors earn far lower average returns than the overall stock market because they are unable to handle the volatility and end up selling when stocks fall, only to buy again after they have recovered. They might be better off, in practical terms, taking the secure return from repaying their mortgage.

But aren't mortgages great tax shelters? Yes and no. Traditionally, one argument in favor of holding a mortgage has been that borrowers can deduct the interest payments from their taxable income.

But thanks to the collapse of interest rates, that tax break isn't worth as much as it used to be. Homeowners paying 3.7% interest on a $200,000 loan can deduct a maximum $7,400 from their taxable income—less than the standard tax deduction, which they can take without even itemizing. Unless they have significant other deductions, the mortgage-interest deduction might not be worth holding on to. . . .

There is one other benefit to repaying your mortgage—sheer simplicity. It is a benefit often played down by financial experts, but many ordinary homeowners prize it.

Some people who repay their mortgages and stop itemizing deductions might find they save money, avoid risk and have a lot more spare time every year around tax season."

Summing Up

So there you have it. Everything is relative, including interest rates.

If we receive less in interest income than we pay in interest expense, it makes sense to pay off our loans with the money otherwise invested in bonds and CDs.

It's just a simple common sense and financially attractive approach to get out of debt and save money at the same time.

And by doing so, we can still maintain the flexibility to reverse course at a later time if interest rates rise sufficiently to make fixed income investments an attractive investment again.

That said, we won't hold our breath in anticipation of seeing substantially higher interest rates anytime soon.

So let's consider taking better control of our finances by giving ourselves a break and paying down our current relatively 'high' interest rate mortgage debt.

That's my take.

Thanks. Bob.

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