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Prepay the Mortgage or Buy I-Bonds?

A reader writes in, asking:

“I have been making sure to make my mortgage a priority the last few months because I realized that is the highest paying fixed income investment I could invest in at the moment because I understand how to compare it to the yield on typical bonds. But when I compare to I bonds, how do I perform this comparison? For example, on the I bonds issued between May and November of this year…is it better to pay my 3.125% mortgage or invest in these I bond issues with composite rate 3.54%, fixed 0%?”

Comparing Risk

As a bit of background information for readers not familiar with I Bonds, their interest rate is made up of two components: a fixed rate and a variable rate.

The fixed rate stays the same through the life of the bond. For I Bonds purchased right now, the fixed rate is 0%.

The second component is a a variable rate that gets recalculated every 6 months, based on the rate of inflation over the prior 6 months (specifically, the change in the Consumer Price Index for all Urban Consumers). For I Bonds purchased right now, the variable rate is 3.54%.

So, today, when we see a 3.54% composite rate, made up of a 0% fixed rate and 3.54% variable rate, we only know that that variable rate will be applicable for 6 months. After that, it could be lower or higher, depending on inflation.

In contrast, if the mortgage is a regular fixed-rate mortgage, we know what the rate of return will be (i.e., the after-tax rate of interest that you no longer have to pay).

Of course, that’s in nominal terms. In real (i.e., inflation-adjusted) terms, it’s the I Bonds that have the predictable rate of return (in this case, 0%, minus any tax you would have to pay on the variable rate), whereas the mortgage has an unpredictable rate of return (i.e., the rate on the mortgage, tax-adjusted, minus whatever inflation turns out to be).*

Comparing Returns

In both cases, we want to look at the after-tax rate of return.

If your mortgage interest is fully deductible, we would multiply the interest rate by 1 minus your marginal tax rate (federal + state, if you can deduct the interest at the state level as well). For example with a 30% marginal tax rate, paying down a 3.125% mortgage would provide a nominal after-tax rate of return of 2.1875% (i.e., 3.125% x 0.7).

And you would also want to adjust the interest rate on the I Bonds accordingly. I Bonds are generally taxable at the federal level. But they are exempt from state income tax. In addition, if the bonds are ultimately used to pay higher education expenses, the interest will be federally tax free as well.**

In short, there’s going to be a break-even rate of inflation at which you are indifferent to prepaying the mortgage as opposed to buying I Bonds.

If taxes were not a consideration, that would be 3.125%. (That is, if inflation is 3.125% over the period in question, both I Bonds with a 0% fixed rate and prepaying a 3.125% mortgage would have a 3.125% nominal return or a 0% real rate of return.)

Considering taxes, we’d want to do some algebra in which we set the real rate of return on the mortgage equal to the real rate of return on the I bonds, and solve for inflation.

That is:

  • mortgage real rate of return = I Bonds real rate of return

The mortgage real rate of return can be written as:

  • after-tax mortgage interest rate inflation.

And the real return for the I Bonds can be written as:

  • fixed rate taxes paid on fixed rate + variable rate taxes paid on variable rate inflation

For I Bonds purchased today, the fixed rate is 0%. And the variable rate will always be equal to inflation. So we can rewrite the real rate of return for I bonds purchased today as:

  • 0 0 + inflation (inflation * marginal tax rate) inflation

Or simply:

  • (inflation * marginal tax rate)

For example, if the mortgage has a rate of 3.125% and you expect a 30% tax rate on the mortgage and a 22% tax rate on the I Bonds, the break-even rate of inflation would be 2.804%.

  • mortgage real rate of return = I Bonds real rate of return
  • 3.125% * 0.7 inflation = 0.22 * inflation
  • 2.1875% inflation = 0.22 * inflation
  • 2.1875% = 0.78 * inflation
  • inflation = 2.804%

That is, with inflation of 2.804% and a 30% tax rate on the mortgage and 22% tax rate on the I Bonds, they each provide the same after-inflation, after-tax rate of return.

Mortgage real rate of return = 3.125% * (1 0.3) 2.804% = 0.617%

I Bonds real rate of return = 0.22 * 2.804% = 0.617%

If you expected inflation greater than 2.8%, I Bonds would be expected to provide a greater after-tax return. If you expected inflation less than 2.8%, the mortgage would be expected to provide a greater after-tax return.


Another important difference between using cash to buy I Bonds and using cash to pay down a mortgage is that buying I Bonds would preserve a greater degree of liquidity. You can cash I Bonds after one year. (If you cash them before five years, you lose the previous three months of interest.) Whereas when you pay down a mortgage, that cash is gone, and there is no cashflow benefit until the mortgage is paid off.

*Throughout this article I am using the simplifying convention of subtracting inflation from the nominal return in order to find the real return. The more precise math is to divide (1 + nominal return) by (1 + inflation), then subtract 1.

**For simplicity’s sake, I am ignoring the fact that with I Bonds you have the choice to pay tax on the interest each year or defer taxation until the year in which you cash the bond or the bond matures. In theory, deferral is an advantage. But the specifics will depend on how your marginal tax rate changes over time.

Financial Lessons from the 2016 Presidential Election

As I mentioned on Friday, I want to share a few investing-related thoughts regarding last week’s presidential election. As always, however, my goal is to keep this nonpolitical.

Models Work Great, Until They Don’t

Nearly all of the experts were saying that a Clinton win was likely, and some were super confident about such an outcome. For instance, the final forecast by The Upshot gave Clinton an 85% chance of winning.

It makes me think of the Long-Term Capital Management blowup of the late 90s or the Lehman Brothers blowup in 2008. (In each case, the people involved created a model for how various types of assets behaved. Then they borrowed lots of money to invest according to their model. Then the models turned out to be flawed, resulting in massive losses.) Modeling complex systems is difficult, and it’s best not to bet heavily that your model is an accurate representation of how the real world works.

Or, in a more common and less risky part of the investment world, it makes me think of the model-based portfolios that I often see advisors create for their clients. You get 3% of your portfolio in Fund A, 6% in Fund B, 15% in Fund C, and so on — because that’s what the model calls for.

Personally, I much prefer to have a very “dumb” portfolio — one that doesn’t rely on any predictions, other than the most basic. Specifically, with our money invested primarily in domestic and international “total stock market” index funds, the only prediction being made is that the publicly traded companies of the world will continue, on average, to earn profits.

Small, Unpredictable Events Can Have Huge Outcomes

Consider what would have happened if the timing of the FBI email announcement and the release of the Access Hollywood video had been switched, such that it was the video that was getting the primary news coverage immediately prior to the election. I wouldn’t be at all surprised if such a scenario would have resulted in a Clinton win.

Point being, a U.S. presidential election is a major macroeconomic event, yet the outcome can be determined by small, unpredictable events. This is a critical part of why it’s so hard to make specific predictions accurately.

Predicting the Market is Hard

On election night, the prices for stock market futures fell considerably. But then on Wednesday the U.S. stock market (as measured by Vanguard’s Total Stock Market Index Fund) actually turned out to rise by a little over 1%.

In other words, it’s as if the market on Tuesday night was saying, “A Trump presidency? Oh no!” But by the very next day had changed its mind to: “Trump presidency? Sounds great!” Over the long term, the market’s performance will ultimately reflect the profits earned by our publicly traded companies. Over the short term, however, it’s nonsense. Trying to predict that nonsense by jumping in and out of the market at just the right times is not wise.

For example, I know of two people who pulled out of the market prior to the election in order to “wait until things calmed down.” But guess what? The election is over, and things haven’t calmed down. Our country is as divided and chaotic as ever. So when do you get back into the market when trying such a stunt?

What to Expect Going Forward?

Several people have emailed to ask what I think we should expect as far as legislative changes. I would say that, with Republicans in control of the White House as well as both chambers of Congress, certain things have become more likely than they would have been under a Clinton administration. For example:

  • Tax rates are more likely to come down,
  • The Affordable Care Act (or critical pieces of it) is more likely to be repealed, and
  • Taxes that specifically affect people with higher incomes and/or net worth (such as the estate tax or the 3.8% tax on net investment income) are more likely to be repealed.

But again, my whole overall point here is that things are less predictable than we like to think they are. There’s absolutely no way to know which (if any) of the above events will occur — much less when they will occur or exactly what the specifics will look like.

The best bet is to use a portfolio that works well in a wide range of scenarios, and to be flexible with your financial planning, when possible.

Finding the Best Time to Invest

As mentioned in a recent article, fellow blogger The Finance Buff has been running an experiment with his IRA contributions for the last two years. Here’s how he explains the experiment:

“Instead of contributing $5,000 at the first opportunity [$5,500 for 2013], I would wait for a small dip because prices almost always go down during the year.

Being chicken little, I didn’t want to wait too long. So I set my limit at 2%. I took a note of the closing price that I would’ve got had I done what I always did in previous years: go all-in on day one. I set an alert based on that closing price minus 2%. If I could get in at a price 2% lower than I otherwise would have, I would be satisfied and call it a day.”

I bring this up because I often receive emails about assorted variations on this type of strategy (i.e., strategies that wait for some specific signal to buy, instead of buying as soon as possible).

Relative to other strategies that attempt to beat the market, these strategies have one big advantage: They’re unlikely to increase costs in any way. (In contrast, many market timing or stock selection strategies result in more frequent transactions, thereby increasing trading costs and taxes. And strategies based on the use of actively managed funds increase costs via expense ratios.)

Because these wait-until-[something]-to-buy strategies shouldn’t increase costs, whether or not they’re a good idea is simply a question of whether the purchase timing indicated by the signal is better or worse than buying as soon as you have the money available.

Is a High Probability of Winning Good Enough?

Given the inherent volatility of the stock market, a 2% decline isn’t very much. Such a decline is likely to happen at some point in most years. In other words, The Finance Buff’s version of the strategy has a high probability of success in any given year.

But, in itself, that doesn’t necessarily make the strategy a good idea.

By way of analogy, consider a game in which you roll a 6-sided die. If you roll a 1, 2, 3, 4, or 5, I give you $1. But if you roll a 6, you have to give me $10. This is obviously not a good game for you, despite the fact that you have a high probability of winning money on any given roll.

In the case of TFB’s strategy:

  • A “win” results in an additional one-time return of roughly 2% (due to having purchased at a 2%-lower price), and
  • A “loss” happens when the market marches steadily upward all year, such that the buy-signal never occurs at any point, so the cost of a loss is missing out on a year of good returns.

So, how can we determine whether the probability-weighted gains from the “wins” are likely to exceed the probability-weighted cost of the “losses”?

Reducing the Number of Days In the Market

The primary attribute of wait-for-a-buy-signal strategies is that, relative to investing the money as soon as it’s available, they reduce the number of days that you’re in the market. (For example, in TFB’s version of the strategy, the excluded period is, “days in each calendar year prior to the first decline of 2% from the year’s starting price.”)  So the relevant question is whether or not the days that you are out of the market have a positive or negative expected return.

Of course, in general, the stock market has a positive expected return. Therefore, for the strategy to work over the long-term, it must be excluding days that are unusual in some way. That is, it must reliably exclude days that have not only below-average returns, but below-zero returns.

If you cannot think of a convincing reason why the particular group of excluded days would have a negative expected return, it doesn’t make any sense to use the strategy. Instead, you would want to invest your money as soon as it’s available to invest.

Selling Investments to Pay Down a Mortgage

A reader writes in, asking:

“I currently have a variable home equity line of credit (now at a 4% interest rate). We’ve currently borrowed $150,000 on the HELOC. We have about $850K in investments, mostly with Vanguard. How do I decide whether to pay off the loan, dropping my investments to $700K, when it seems I make about 5% on the investments?”

One way to look at the situation is that you’re simultaneously borrowing money at 4% while lending money to somebody else at a rate equal to the yield of the bonds in your portfolio. (For a Vanguard Total Bond Market holding, that would be about 1.5% right now.)

That would certainly suggest that it would be a good idea to liquidate some of your bond holdings in order to pay off the loan. But there are a few counterpoints that should be considered first.

Comparing (After-Tax) Apples to (After-Tax) Apples

The line of credit’s after-tax interest rate is likely lower than 4% when you consider the value of any deduction you’re currently getting for the interest. In contrast, if your investments are completely tax-sheltered (i.e., not in taxable accounts), then there would be no need to reduce the interest rate on your bonds in a similar fashion for comparative purposes. In other words, the spread between the two interest rates may not be as high as it appears at first glance.

Paying to Maintain Liquidity

In some cases, it makes sense to simultaneously borrow money at a higher rate than you’re earning on your lowest-earning holdings because doing so allows for greater liquidity, which offers a degree of protection against unexpected large expenses.

In this case, however, that’s unlikely to be a concern given that:

  1. The line of credit would still be there, available for a cash crunch, even if you paid it down, and
  2. A mutual fund portfolio well into the 6-figure range provides plenty of liquidity as well.

Additional Tax Considerations

Another thing to consider is the tax consequences that would result from liquidating holdings in order to pay off the line of credit. The answer to this depends on:

  • Where the investments are held (e.g., Roth IRA vs. traditional IRA vs. taxable account),
  • Your age and current tax bracket (if they’re held in a tax-deferred account), and
  • Your cost basis in the investments (if they’re held in a taxable account).

For instance, if the investments you would be liquidating are all in tax-deferred accounts, even if you do decide you want to go ahead and pay off the loan, it might make sense to do it over 2-3 years rather than all at once, because such a large distribution in one year from a tax-deferred account would likely bump you into a higher tax bracket, and the additional taxes paid (relative to spreading it out over 2-3 years) might outweigh the interest saved.

What About Borrowing to Own Bonds and Stocks?

Finally, some people would argue that the appropriate comparison is not the interest rate on your bond holdings as compared to the rate on the line of credit, but rather the average return on your total portfolio as compared to the rate on the line of credit — with the reasoning being that having the bond holdings is what allows you to have the stock holdings without exceeding your emotional/mental tolerance for volatility.

The Perfect Portfolio: Don’t Bother Trying

I write a lot about improving your portfolio, whether it’s by choosing an appropriate asset allocation, minimizing costs, or minimizing taxes.

All of those things are important. But it it’s also important to recognize that, no matter how hard you try, your portfolio will never be perfect.

Extreme Optimization

I recently had an email conversation with an investor who had determined that, by moving his IRA to a different brokerage firm and shifting the holdings in his 401(k), he could reduce his average expense ratio by 0.05% per year while keeping the same overall asset allocation.

On this investor’s roughly $100,000 portfolio, reducing costs by 0.05% would have amounted to $50 of savings per year. Saving $50 every year certainly isn’t a bad thing, but it’s unlikely to make or break his retirement plans. And it might not be worth the hassle of moving accounts from one brokerage firm to another–especially given that his current brokerage firm could end up being the lowest-cost choice a few years from now.

Analysis Paralysis

Similarly, I often receive emails from people who recognize that their holdings are a mess and that something needs to be done about it, but they can’t bring themselves to make any changes because they want to have everything “just right” before pulling the trigger.

Of course, “just right” never happens. There are a thousand different asset allocations that could make sense for a given investor, and you could spend months (or even years) trying to research and answer all the possible questions:

  • Should you use ETFs or index funds?
  • Should you use Vanguard or Fidelity?
  • Should you have 45% of your portfolio in stocks or 60%?
  • Should you invest 20% of your stock holdings internationally or 40%?
  • Should you overweight small-cap/value stocks?
  • Should you have a specific allocation to REITs?
  • Should you own any bonds other than Treasuries?
  • Should you own international bonds?
  • Should you stick with short-term bonds, intermediate-term bonds, or both?

All of those questions (and many others) have reasonable arguments that can be made on each side. If you try to find the “right” answer to each and every such question, you’ll never get anywhere.

At some point, you have to accept that your portfolio will never be perfect. Perfect portfolios do not exist. But good portfolios do. And a good portfolio can get the job done.

Roulette ETFs For Today’s Market Conditions

Mike’s note: Since I first found my way to the Bogleheads forum, one of the members I’ve most looked up to is an anonymous writer by the name of nisiprius. He’s always impressed me with his wit and insight, so when he offered a guest post in reply to last week’s “asset allocation comes first” article, I jumped at the chance to publish it. I hope you enjoy it. 😉

Investors are taking a fresh look at roulette ETFs, which invest in bets on roulette wheels at casinos. Roulette gambling has long been used by hedge funds and university endowments, but was formerly out of reach of individual investors due to the time and cost of travel, and the difficulty of diversifying among casinos. But ETFs now provide low-cost access to this asset class.

Bram Stoker, senior analyst at Transylvania Capital Management, says “roulette spins have been shown to have low correlation with stocks, making them a powerful diversifier in a portfolio.”

It is important to understand the differences between roulette ETFs, because they don’t all work in the same way, so look under the hood before deciding which of them you need to add to your portfolio today.

Mike’s note: I’m 95% confident you’ve all figured this out by now, but just in case: This article is a satire, poking fun at (among other things) the product-focused nature of the mainstream financial media.

Index roulette ETFs, such as Roquefort’s ROQ, simply bet on red and black equally. Roquefort uses random numbers generated by a proprietary atomic decay device, and cites academic research that claims this reduces the standard deviation compared to traditional selection methods.

Roquefort also offers two chromic strategy ETFs: REDS, which always bets on red, and BLAK, which always bets on black. Stoker notes that these are riskier: “Be sure you know which color you like before investing.” Roquefort has just introduced OO, which bets on the double zero. The potential for 3500% returns is attractive, but Roquefort notes that due to volatility it may not be suitable for all investors, only for better-than-average investors like you.

Nisiprius Investments Ltd. says that its global roulette fund, WHEE, places bets in Monaco, Macau, Antigua, Baden-Baden, Moscow, and Sun City, South Africa. We talked to fund manager Blaise Pascal, who said “Why are you pestering me with all these silly questions? It’s global, what more do you need to know? Global! Global! Global! Do you hear me, global!”

Strategic Cluster Asset Modeling is a new entrant, providing two actively managed ETFs, CLUS and CLUD. CLUS follows a progressive cluster roulette gambling system, backtested with 40,000 spins. Spokesperson Mary Martingale says it could offer the possibility of a conceivable potential for steady winnings regardless of what the wheel does. CLUS is only for sophisticated investors. The minimum investment is $250,000, and you must include a photograph and three letters of recommendation with your application. CLUD, the 2X leveraged version of CLUS, has a minimum investment of $500,000 and you must send two photographs and six letters of recommendation, and the existing shareholders can blackball you. With $1.35 million assets under management, CLUD is off to a fast start, and both of its shareholders think the world of it.

What is an appropriate roulette allocation? “We are currently recommending allocations of 5-10% to all our clients,” says Stoker. “We think roulette will prove to be a valuable addition to their portfolios. We follow market trends closely, and if roulette doesn’t pan out we’ll have other hot asset classes to recommend, but what with the end of QE2, the sideways trend in the VIX, and uncertainty about the possible end of the world, our analysts think roulette is the place to be today.”

I asked Stoker whether the house percentage could cause the long-term return of roulette funds to show a long-term trend in any particular direction. He replied “Investors who limit their portfolio to assets with positive long-term returns are pathetic losers who are going to miss out. An asset may do nothing but lose money, yet improve the portfolio as a whole. Some guy once won a Nobel prize for showing how bonds help stocks. The correlations for roulette are even lower! You must not consider roulette in isolation, you must consider how it works in the portfolio as a whole.”

Which of these roulette ETFs will you add to your portfolio? Only you can answer that question. But you better add at least one of them. Today!

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