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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.

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Comments

  1. Gary Thrasher says:

    I’m new to your website and have enjoyed reading the email updates from you and the other contributors.
    I have a question… I’m looking at investing in the Vanguard Balanced Index fund and noticed the high turnover rate… why is it so high on an index fund.. and should I be concerned about it at all because of the low managment cost?

  2. Gary,

    With bond funds (and, to a lesser extent, balanced funds), turnover tends to be much higher than for stock funds, due to a) bonds maturing and/or b) the fund selling bonds as they move out of the maturity range that it’s trying to stay within.

    To give an extreme example, Vanguard’s Short-Term Treasury Index Fund has a turnover in excess of 300%.

    If your concern is whether they’re doing something that is increasing costs not included in the expense ratio, one useful (though not bulletproof) test is to compare the performance of the fund to the performance of its benchmark and see if the fund is trailing by an amount greater than its expense ratio.

    With the Vanguard Balanced Index Fund, it looks like there’s been a little bit of tracking error over the last few years, but at the 5-10 year range, the underperformance is very close to the fund’s expense ratio.

  3. “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.”

    I agree with the rest of your points, but people who would argue the above are wrong. Period. See this excellent article by Michael Kitces at Nerd’s Eye View for a discussion of the effect of housing-related debt on one’s portfolio:

    http://www.kitces.com/blog/archives/313-Why-Keeping-A-Mortgage-And-A-Portfolio-May-Not-Be-Worth-The-Risk.html

  4. Building on “Another thing to consider is the tax consequences that would result from liquidating holdings in order to pay off the line of credit”

    With 3.8% Surtax looking like it is sticking around the investment income might push you over the edge of 200K/250K where not only your marginal rate is increased but also you hit the surtax

  5. Nice article. Another key consideration for the after tax cost of interest is the taxpayer’s level of itemized deductions compared to the standard deduction. For 2012, the Std Ded is $5950/$11900 for Single/Married taxpayers. If your itemized deductions are not above this amount, the interest deduction is not really helping and the after tax interest rate would be the same as the nominal rate.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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