I've come into a large amount of money. Should I invest it or pay off my mortgage?
This is an age old question and the answer varies from person to person. There is rarely a right or wrong answer to this because there is more to the decision than just economics. It should also be noted that much more information would be needed to evaluate the pros and cons of your situation. Having said that, here are some questions to work through.
Are the funds you received tax deferred or have they already been taxed? This makes a big difference because the tax cost could out-weigh the interest savings via pay off. I wrote an article that goes through various types of taxation called Tax-deferred vs Tax-free Investment Accounts that you might find helpful.
How far along are you in the mortgage? When you are near the tail end of the mortgage, most of your payments are being applied to principal. Therefore, there is less savings to be had than if you were paying off earlier on into the mortgage.
What type of investment are you considering in lieu of paying off the mortgage? How liquid your funds are is a huge factor. If you invest in something where your funds are locked up, you lose flexibility. There is an expression that “cash is king” and depending on how much cash you have after the mortgage is paid off should be considered too.
You might consider reading this guest post on my site called Should I Pay Off My Mortgage Early Or Invest? It is an excellent resource that walks through the pros and cons.
Please note that this should not be considered investment advice and is only educational in nature. Be sure to consult your own investment, tax, or legal professional for help with your specific situation.
Best of luck!
David N. Waldrop, CFP®
There is no obvious answer. It all depends on your specific situation and your tolerance for investment risk.
From a pure economics standpoint, if you think that the after-tax return that you expect to earn from investing your new sum of money is higher than the after tax cost of the mortgage, then it makes sense to invest the funds rather than to pay off the mortgage. That's the theory.
In practice,you should consider where you stand on the financial life cycle. No matter what the economics, if you are close to retiring, getting rid of your debts should be a higher priority than if you are in your thirties for example. Additionally, managing funds requires investment skills and temperament that many people do not have. You also need a bit of luck. Going back in time a bit, if you were asking this question in November 2007 and had decided to invest, no matter what your level of investment skills, you would have quickly regretted not paying off the mortgage.
There is a risk with investing the funds that you do not incur by paying off the mortgage. Your level of risk tolerance matters. I hope this helps.
How about both? Invest in a portfolio of stocks that pay a dividend and have historically increased their dividend over time. Receive the dividends as cash and use the added income to pay extra on your mortgage, or reduce your out of pocket mortgage expenses. In the end, you will have a paid off home AND a nice portfolio.
I'm a fan of a paid-off mortgage. Many people will tell you not to give up the tax write off from mortgage interest. However, if you look at it as a whole part of your finances, that makes no sense. Say you are paying $10,000/year in mortgage interest and are in the 25% tax bracket. Your IRS write off will amount to about $2,500 back to you at tax time, but that's still $7,500 that just goes to interest to the bank. In other words, the write off still leaves you $7,500 in the hole for cash flow.
If you don't think you will be in the house for very long, don't pay off the mortgage and tie up the money in an illiquid asset (the house). If you do plan on staying in your house for 5 years or more, pay that debt off and enjoy mortgage-free living.
When I get a large sum like that, I'm going to invest it. My number one financial priority is independent wealth. To achieve this, I need enough money to be under financial management so that, assuming a prudent interest rate, the annual yield will be enough to pay my expenses and support my lifestyle. This way, I can work because I want to, not because I have to.
Becoming debt-free is a secondary objective. I certainly don't want any debt, because that inhibits your freedom. But I’d be willing to carry a mortgage and consider the payments to be normal expenses if I could have a lump sum spinning off income to pay those bills.
Given the choice between being debt-free (no mortgage) and work-free (don’t have to work to pay my bills, even debt payments,), I would choose the latter easily.