Paying Off Mortgage Versus I-Bonds

Reader Question

Hi LTR, love following your blog, great insight! I just set up a treasury direct account and was just getting ready to invest in $20K of I savings bonds as you suggest, but then thought maybe I should pay down $20k on my rental property mortgage instead? I have $200K savings invested in 401k, roth, stocks, cash, etc. but wonder you opinion on carrying mortgage debt? I have $50K mortgage at 4.38% APR, 12 years left on loan. I have been holding onto cash in case I want to make new investment, but do you recommend I pay off the mortgage? It is a single family rental property that's still posting an annual loss, but about to be profitable this year. Thanks!

My Reply

Yes, assuming this is not emergency fund money (and if it is, then remember that I-Bonds are not redeemable for the first 12 months), you should absolutely put the money toward paying off the mortgage instead of investing in I-Bonds or pretty much any other fixed income today.

Ignoring possible differences in tax treatment, paying off mortgage debt at 4.38% is equivalent to investing in a bond that pays 4.38%. Currently no 12-year investment comes close to guaranteed 4.38%, so paying off the mortgage (or at least paying down $20,000 of it) is easily your best bet. The only way it might backfire is if we encounter very strong inflation of over 4.3% in the next 12 years, which would make your I-Bond earn more than your interest on the mortgage. Such inflation is not impossible of course (1970s saw quite a bit worse), but there is no reason to believe it's coming. The market expects inflation of under 2% range for this time period. It's also conceivable that interest rates might spike without inflation, but as before, there is simply no reason to expect it.

Taking taxes into account can make the picture a little more complicated. But even if you are in the highest tax bracket and your rental mortgage interest is fully deductible, you are still left paying around 60% of 4.38% or around 2.6% in interest. That rate is still higher than I-Bonds or other investment-grade bonds are likely to deliver after tax (remember that you will owe taxes on I-Bonds when you finally redeem them) in the next 12 years. It's possible that muni bonds may come close or beat this number, but it's certainly not guaranteed. And most likely your effective post-tax interest is higher than 2.6%.

Until and unless interest rates rise significantly I would absolutely put any money destined for fixed-income investments, such as these $20,000, toward paying off this mortgage first. The only other possibility is if you could refinance at a significantly lower rate, but my guess is that you won't be able to improve on your current rate much since it's a rental property -- plus refinancing will have its own costs. Paying down a 4.38% mortgage is an easy choice here.