Suppose you have $200,000 in bonds—and you also have $200,000 in mortgage and other debt. You should think of those debts as “negative bonds” and subtract them from your bond position. Result: In this example, your net bond position is zero. After all, while your bonds are paying you interest, your debts are costing you interest. In fact, the interest rate charged on your debts is likely greater than the interest you are earning on your bonds.
The implication: Instead of buying more bonds, you might use your extra savings to pay down debt. You may even find that, because your debts are costing you more than your bonds are earning, it makes sense to sell your bonds and use the proceeds to reduce debt.
What if we’re talking about mortgage debt, with its tax-deductible mortgage interest? Let’s say you have a 5% mortgage and you’re in the 25% federal income tax bracket, so the effective cost of your mortgage is just 3.75%. Fingers crossed, you should be able to earn more than that over the long term by purchasing a diversified collection of stocks.
What if the alternative is to buy bonds? Suppose you can buy bonds that yield 4%, which is higher than the 3.75% after-tax cost of your mortgage. That might seem more attractive. But if the 4% bonds pay taxable interest and you hold them in a regular taxable account, you might be left with just 3% after paying taxes—which means paying down the mortgage will give you a better return.
Our Humble Opinion: Even if the potential gain from investing is higher, there’s still great virtue in paying down debt, even low-cost, tax-deductible mortgage debt. The return is guaranteed, it makes your overall finances less risky and ridding yourself of all debt is a crucial step on the journey to a comfortable retirement. Not sure whether it’s a good time to buy stocks or bonds? When in doubt, you can do a lot worse than pay down debt.
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