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Pay It Down Slowly, Part II

Pay It Down Slowly, Part II

Betting the house on higher interest rates.

In last month's column, I offered you a well-reasoned argument as to why your clients should not only pay off their mortgages as slowly as possible, but consider taking out a new, 30-year fixed-rate mortgage for as much as their friendly lender would allow.

Some suggested places to put the money from the mortgage included boosting up pre-tax retirement plan contributions, paying down other high-interest, non-deductible debt, or setting it aside to pay cash for future purchases or emergency expenses.

But another lesser-known advantage to getting a new fixed-rate mortgage is that it can serve as a potential hedge against higher inflation (and interest rates). However, there are only a few places you can put the mortgage money to protect it from such a scenario.

The Conundrum

Clients who buy into the idea of extending and expanding their mortgages will naturally have a follow-up question: “What should we do with the extra money?”

Despite your stock market prowess, you would have a difficult time guaranteeing that their future equity investment results will more than offset the guaranteed interest rate cost of the mortgage.

Bonds and fixed income funds might be a less-volatile solution. Yet the anticipated higher rates that would make the new mortgage pay off could also eviscerate the market value of the otherwise-conservative interest-bearing portfolio.

There are a couple of places your clients could park the cash that may earn them a decent rate of return, protect most or all of their principal in a rising-rate environment, and still give clients the option to cash in the accounts and pay off the mortgage if the need (or mood) should so arise.

Certificates of Deposit

Sure, you can buy brokered CDs for your clients through your firm, perhaps getting them a higher yield and/or access to a stronger institution than what they could get on their own. But usually the only way clients can get the money out of those CDs before maturity is to put the bonds up for bid in the open market. If that's done after interest rates have risen, the clients may be forced to either sell at a loss, or wait until maturity to get all of their money back.

A more preferable alternative might be for the clients to take out a certificate of deposit at a local institution on their own. Many banks and credit unions still only impose a “substantial penalty” of three to six months of interest if a CD is cashed in early — a small price to pay to put a floor on potential losses.

Two things your CD-shopping clients should know. First, if they can find a certificate with a minimal early-withdrawal cost, they should consider taking out the CD for as long as possible. They'll get a higher rate of interest, be protected in the event rates go or stay lower, and be locked into the advantageous early-withdrawal terms for a long time.

Also, the FDIC has bumped up its insurance limit to $250,000 per person per institution — and more could be covered depending on how the CD ownership is titled. However, that higher insurance ceiling is scheduled to revert to the more-familiar $100,000 level in 2013. So going longer than that with larger amounts could leave your clients with uninsured money at an institution. Therefore, they would be wise to scatter larger amounts among several different banks or credit unions.

Rock-Solid Savings Bonds

Another vehicle that offers safety and protection of principal in the face of rising interest rates are U.S. Savings Bonds. The interest is competitive with that paid by CDs and Treasuries, and is exempt from state income tax as well. Plus, the bondholder can choose when to declare (and pay federal income taxes on) the interest: either annually or when the bonds are redeemed or mature. So those who might be in a lower tax bracket later (such as during retirement) can choose to delay declaring and paying taxes on the interest now.

Both Series EE bonds and Series I bonds pay interest for 30 years. The Series EE is a fixed-rate bond, and the Series I bond interest is based on two components: a small fixed rate that lasts over the life of the bond, and an added floating component that's tied to the Consumer Price Index, and adjusted each May and November.

The Series I bond is especially attractive to those who fear (or hope for) higher inflation and interest rates. But what makes either the EE or the I attractive in the face of inflation is the minimal friction involved in cashing the bonds in early.

Savings bonds must be held for at least 12 months. But after that period has expired, the only penalty for early withdrawal is three months of interest. Once the bonds have been held for five years, they can be cashed in with no penalty whatsoever.

The only drawback of savings bonds for this use is that only $10,000 of bonds per Social Security number can be bought each calendar year. To even top out at that small amount, bondholders can buy no more than $5,000 of bonds annually in person (at a bank or credit union), and an equal amount online at

Time for TIPS?

Bond buyers looking for lots of safety, a little yield, and some protection against inflation would also be wise to look at TIPS (Treasury Inflation-Protected Securities). Like Series I savings bonds, the yield on TIPS is tied to the Consumer Price Index, and the yield rises and falls generally in line with the CPI. As with savings bonds and other Treasury issues, interest on TIPS is exempt from state and local income tax. However, unlike savings bonds, TIPS owners have to report interest accrued on an annual basis.

Another strike against TIPS as an inflation hedge is that, yes, in theory a rising CPI would boost the yield of the TIPS up as well, and hopefully mitigate much of the loss in market value that a similar fixed-rate bond would incur. But the only way a TIPS owner can cash out of the bond before maturity is to sell it in the open market. Which means that if rates rise higher and faster than the CPI, clients might experience a loss in value over what they originally paid for their TIPS. And that would cause them to regret “betting the house” on higher interest rates.

Writer's BIO:

Kevin McKinley
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at

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