En español | Interest rates have plunged faster than the COVID economy. Merely two months ago, one could find CDs yielding about 3 percent. Now, both CDs and a high-quality bond fund such as the Vanguard Total Bond Market ETF (BND) are yielding only 1.65 percent before taxes. Yet millions of Americans can earn 3 to 5 percent by paying down their mortgage and far more by paying off any credit card debt.
Bonds and mortgages
Bonds are IOUs issued by the government or corporations. You buy bonds because you want regular, reliable interest payments, and because you want some buffer against the stock market's wild zig-zags. You don't want any excitement from bonds. And, assuming the issuer doesn't default, you won't get any. When the bond matures, you get your principal back, which you can then invest elsewhere.
A mortgage, like a bond, is an IOU. In this case, however, you're paying the interest, and the bank is receiving it. The bank doesn't want excitement from its investment any more than a bond investor does. It simply wants regular interest payments over time and on time as well as getting the loan principal back.
Let's say you are married and have a $100,000 mortgage at 4 percent. You'll pay about $4,000 in interest to the bank, and likely will not be able to itemize your deductions, according to the Tax Foundation, a nonpartisan tax policy nonprofit. Why not? Most married couples will take the $24,800 standard deduction, so unless you have a very large mortgage, your interest payment won't lower your taxes.
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Pay yourself, not the bank
If you happen to have enough cash or bonds to pay off the mortgage, doing so would create roughly $4,000 of tax-free equivalent income. By comparison, you may only make about $1,200 after taxes with a CD or high-quality bond fund. Even better, paying off your mortgage helps your cash flow, since you won't be paying the bank principal payments either.
Okay, so you may not have $100,000 in cash and bonds to completely pay off the mortgage. But even if you have $10,000, that's roughly $400 a year of the equivalent tax-free income. Though your payments won't likely change, that's about $400 a year of additional money going to pay off principal so that $400 is also paying yourself. You'll also end up getting rid of the mortgage more quickly.
You will hear many people tell you not to pay off your mortgage. They may say something like “A balanced portfolio of 60 percent stocks and 40 percent bonds can earn more than what you'd gain by paying down your mortgage.” Though this may be true, it is more a case of comparing apples to oranges. Stocks are risky, as we've just been reminded. And, by the way, so far this century bonds have earned more than global stocks.
Also, I sometimes have people tell me they don't want to put more money into the house. While I agree with this statement, it's irrelevant. I'm not suggesting a house remodel here. Paying down the mortgage has no impact on the price you ultimately sell your house for, or whether you put in marble countertops. You're simply eliminated a debt and increased your cash flow.
Pay the biggest debts first
Of course, if you have more expensive debt, that should be paid off first. Credit card interest rates have been averaging 17 percent, according to Wallet Hub. So even if you spend your $2,400 coronavirus stimulus checks paying down your debt, that's a savings of $408 a year. Try to get that from a CD.
The drawback of paying off debt is that you may not be able to get that money back should you need it for an emergency. If there's one thing the coronavirus has proven, it never hurts to have an emergency fund. Make sure you have enough access to cash to be able to sleep at night before sending it to the bank. Remember that banks make money by charging borrowers higher rates than they pay depositors. Money that isn't going to the bank will go to your pocketbook. And tax laws make it even sweeter.