1

One of the typical reasons mentioned to not pre-pay a mortgage is that the interest is tax deductible and therefore the effective rate on the mortgage is much lower. However, this argument doesn't seem to make sense if the mortgage rate and treasury rate are equal.

Suppose I have a fixed-rate mortgage at 3% interest and the duration matches a 10-year treasury which also pays exactly 3%. Further assume that the federal income tax rate is 20% and contributions to all tax advantaged investment plans have been maxed out.

If I have $1000, after-tax, to invest then I can either pay down the mortgage or buy a treasury.

If I pay down the mortgage then I have saved $30 in interest, but I would have deducted .2*30 from federal income tax so I have actually saved $24. In other words, I'll have $24 extra dollars in my pocket after a year.

If I buy a treasury then I get $30 of interest, but I have to pay the tax-man his 20%. Therefore, I am left with $24 after April 15th.

My question is: other than "liquidity", is there any benefits to buying a treasury over paying down a mortgage with after-tax money when the interest rates are similar?

Thank you in advance for your consideration and response.

4

The tax-deductibility of interest is a piece of the puzzle, but not "the" reason to not pre-pay.

I highly recommend you read another question here, Oversimplify it for me: the correct order of investing. It's not quite a duplicate, as your question is very narrowly focussed. On the other answer, both the top rated/accepted answer and mine suggest that paying early is the last priority, of our top 6. If, in fact, you are at point 6, and prefer the safety of the pay down, yes, do it. A year or two from now, treasuries may be 5%, and if you set aside an extra $20,000, the delta is 2%, or $400/yr. No doubt, many would prefer to pay the mortgage early and sleep more soundly.

I don't know anyone saying to keep a mortgage "for the deduction", only to look at the debt the same as you look at your investments, on a post tax basis.

I also don't know anyone suggesting to take the money from potential prepayments and invest in in treasuries. The typical choice is between paying the mortgage, a guaranteed 3% gross return on the funds, in your case, vs a long term investment in stocks, a return of about 10%, but with a standard deviation of nearly 20%. I chose to invest, and documented this in an article I wrote titled "Retired, With Mortgage." The punchline of that article is that even with 2 crashes, 'not' accounting for the interest deduction, and ignoring any matched 401(k) deposit, 3 years ago we had a mortgage balance of $233K vs $453K from the deposits that would have paid off the mortgage. I haven't updated the numbers on the article since then, but the mortgage is now $175K, while the S&P in the 3 years '15,'16,'17, had a CAGR of 11.4%, up 38%. More than covering the payments.

The approach I describe is not for everyone. But consider how many are happy to bet on the 4% rule for retirement planning. It has a 90% or so success rate. In my case, the odds were far better, and the article was written when the average mortgage rate looking backward was 6%, not the 3% you enjoy.

2

In the US, an "elephant in the room" aspect is the so-called "mortgage insurance" or PMI.

Simple fact, PMI is interest under another name. It's an absurd word game. **

In fact, actual interest is very high until you reach the equity point where PMI is eliminated.

(I believe it's 20% usually right? Perhaps more for large mortgages.)

(In almost all cases I believe, it is hugely advantageous for folks to quickly pay to the point of eliminating the PMI. As far as I know.)

The PMI-nomenclature tremendously affects your Treasury Rate question, I believe.


** Oh wait, the government doesn't hand out a tax break on the part of the interest named "PMI" right? Man, what an astonishing coincidence.

  • "to quickly pay to the point of eliminating the PMI." - PMI gets dropped after the natural amortization time has the LTV hit 80%(or 78%). If you pat ahread to the LTV, you have to request it be dropped, probably pay for an appraisal, and likely fight with the lender. A +1 for your warning. – JoeTaxpayer Jul 20 '18 at 17:25
1

I'm old enough to remember when rates FELL to 8% for a 30 year mortgage. Back then people made extra payments on homes and cars because it was a huge financial savings.

It's still a savings, but I don't think there is much value in repaying it early. Especially if you live in the same home longer than the average 10 years and your income increases.

  • OTOH, if you live in the same place long enough (and don't refinance &c), then eventually you get to the point where the interest (plus other possible itemized deductions) is lower than your standard deduction. – jamesqf Jul 20 '18 at 16:13

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