LeRainDrop wrote:I am very intrigued by this concept you raise, DH. I had not thought of this before, but I intrinsically like the idea -- it's like you're paying off your mortgage, except that you're maintaining flexibility with the "extra payments" instead. Would something like VBTLX or VBILX qualify for the types of bonds you are referring to?
I think either of those would be fine. VBTLX is the Vanguard Total Bond Market Index fund. It yields 2.65% right now and has a duration of 4.97 years. That means if interest rates rise by 1% you can expect the price of the fund to decline by 4.97% about 2 years of interest. That's not great but it's not too risky. You can also expect that the yield would increase by the 1% so you'd be getting more return at the same time.
If that happened twice (a 2% interest rate rise) your principle would go down about 10% but you'd be getting a yield of 4.65% on the principle. The 2.65% yield is already close to the effective after-tax yield of paying toward a mortgage so it's already almost a wash. If your yield goes up you will be making more return on the bond fund that it costs in not paying extra on the mortgage. (But to be fair I guess we must calculate the yield on the total amount you had put in since you'll have less money earning the higher yield.) If you run the numbers it seems to work. I would definitely encourage you to do the analysis for yourself to confirm it for your situation. Don't forget that your bond fund yield is taxed lower than the mortgage deduction as well
VBILX is Vanguard's intermediate bond index. It yields 3.13% with a duration of 6.46 years. So there you'd get a little higher yield with somewhat more risk.
This is a little bit speculative. Bond funds are much more predictable than stock funds though. And there is a good chance that the funds managers can keep the fund's price from going down as much as expected by shortening the duration when an interest rate increase seems more likely. The Fed has stated a recipe for when this will happen too so no one should be surprised. But the VBTLX follows an index so it may actually not be as well protected.
Personally I use the T. Rowe Price Corporate Income fund for my mortgage offset pool. It yields about 3.75% and has a duration of about 7 years. I am taking a little risk but I am comfortable with that. Of the two funds you mentioned I think I would prefer the VBILX because it does not have to blindly follow an index. The trouble with following a bond index is that record low rates are causing corporations, countries, and the US government to refinance debt by issuing long term bonds and repaying shorter term higher rate notes. This is driving out the duration of indexes and setting up a potential long bond bubble. When rates eventually rise the longer term bonds and funds will get hurt the most. That's why some active management and keeping an eye on the duration of your fund is a good idea.
Really though, taking this approach is not about yield over the next few years. Right now it is roughly a break even. You can do it with little or no risk right now and basically make a bet that the average bond return over the next 30 years (or the remaining term of your mortgage) will be higher than your mortgage rate. With rates at historic lows, that seems like a fairly safe bet.