Buy Savings Bonds or Pay Off Mortgage Early?

by Michael on Feb 4, 2013 · 3 comments

Image of a House Made of Money

A reader named John recently asked about the wisdom of buying I-Bonds vs. using that money to make mortgage pre-payments.

If I have a mortgage, would it not make sense to pre-pay it rather than buy I-Bonds? Or am I missing something?

This is an excellent question. In fact, it’s exactly the sort of thing that every mortgagee should ask themselves when deciding whether or not to invest any money they may have lying around.

If you look around, you’ll find tons of opinions on why paying off your mortgage early is a good or bad idea. Most of these hinge on risk aversion and the emotional benefits of paying off your mortgage vs. the (potential) mathematical benefits of investing with cheap money.

In the present case, I would argue that I-Bond interest rates are so low that it doesn’t make much sense buy them instead of pre-paying your mortgage. Of course, if inflation spikes, you might regret this decision.

I say this for several reasons.

First, and most obvious, if inflation spikes then I-Bond rates could reasonably exceed your mortgage rate, meaning that you’d be better of owning the bonds and paying your mortgage interest. But the longer it takes for this to happen, the bigger the differential needs to be.

Second, savings bonds are subject to annual purchase limits (currently $10k/year). Thus, if you forego your purchases now, you won’t be able to make up for it in the future. And if we get into a sustained period of high inflation, you may kick yourself for not having maximized your stash.

Third, mortgages themselves provide a degree of inflation protection. The reason for this is that you’re borrowing the money in today’s dollars but paying it back with tomorrow’s dollars. Thus, your payments get progressively cheaper as the value of the dollar shrinks due to inflation.

With all of this being said… When presented with a choice between buying savings bonds and pre-paying our mortgage, I would do the latter. In a heartbeat.

In our case, this is purely theoretical. We paid off our mortgage several years ago and we haven’t regretted this decision one bit.

1 Reddy February 8, 2013 at 11:59 am

Michael: If one has a 2.875% 10 year fixed and can deduct the interest in taxes and is in the 28% tax bracket, would it be better to pay off the mortgage rather than using the extra money to invest in a new rental property to take further advantage of the current low rates and expected high inflation in the years to come.

Please advise.

2 Brick By Brick Investing | Marvin February 8, 2013 at 9:22 pm

I agree that paying off your mortgage is the best decision a person could make. Investments are always speculative no matter how low risk they are advertised to be but a mortgage is a fixed price. By paying off your mortgage you are essentially saving money and once the house is paid off your cash flow will increase significantly.

3 Michael February 9, 2013 at 9:36 pm

Reddy: I’m sorry, but I can’t really say what’s best for you. What I can say is that if you’re concerned about the possibility of high inflation, a fixed rate mortgage is one way to hedge against it.

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