Should I pay off my mortgage loan or invest with the money I am receiving from an inheritance?
My spouse and I will be inheriting about $750,000 to $800,000. The payoff balance of our mortgage is estimated at about $180,000 at 3.5 percent APR for 30 years. Would it be worthwhile to allocate some of the money we are inheriting to pay off the mortgage loan? We still have 27 years left to pay. Alternatively, should I invest the money and continue paying my mortgage?
This is a common trade-off question among families who have a substantial liability like a mortgage and also have a substantial asset – in your case an inheritance, but also appreciated company stock or stock options, or simply other savings.
Let’s presume that your original mortgage was $200K, 30 years at 3.5%. At present, you’re paying about $900/month, of which about 60% is interest and 40% is principle. You’re getting a tax break on the interest amount, so your after tax cost is closer to 2.75%. Meanwhile, you could invest in a balanced (70% stocks/30% bonds) portfolio of tax efficient ETF’s and obtain 6.5% (our projection net of advisor fees over the next 20 years.) So why wouldn’t you just invest in the market and pocket the difference of 3.75%? Well, of course, the 3.5% is locked in, but the 6.5% is ONLY a projection – you could have a couple of poor stock market returns and really regret not just paying off the mortgage.
Ah, but that’s the advantage of the balanced portfolio over a pure stock portfolio. 30% of $800K in bonds is $240K reserved in stable value securities. You could pay off the mortgage at any time from the bonds, and still have funds working in the stock market for when it recovers (and it always does.)
Let’s say your $800K does indeed return 6.5% on average, so $52K in the first year. You can easily route an extra $1000 a month in principal pay-down to your mortgage, which reduces the remaining term from 28 years to 10 – play with this calculator https://www.bankrate.com/calculators/home-equity/additional-mortgage-payment-calculator.aspx for more ideas. At that point, your investment portfolio, net of $12K/year, should be worth around $1.3 million. Alternatively, you could payoff the mortgage entirely now, invest $620K in the same strategy. After 10 years, your portfolio would be $1 million. If you also invested the $7200/year in cash flow savings from retiring the mortgage, your portfolio would grow to $1.15 million.
Our net recommendations:
- Balanced (stocks and bond) not all stock portfolios for the assets
- Commit to extra principal payments to cut the life of the mortgage in half
- Preserve the tax benefit of the interest deduction for now
- Preserve the decision making flexibility in investments that is not available in illiquid real estate equity.
David Edwards, President
Enjoy my videos!
Building a Financial Plan is easy...right? – 30 seconds
Behavioral Finance - why we buy high and sell low – 14 minutes
Explore Heron Wealth’s personal financial dashboard – 2 minutes
The inheritance has certainly unexpectedly strengthened your financial situation and has given you an opportunity to become debt free. I personally do not care what interest rate you are paying on your mortgage because it pales in comparison to having no mortgage on your home. The positive monthly cash flow from having no mortgage payment for the next 27 years supersedes the tax benefits of the mortgage interest. You and your spouse will feel much better by doing so. You will still have about $620,000 left in cash after paying off the mortgage assuming you receive $800k. The cash balance can go toward investing, fully funding Roth IRAs, assuming your income qualifies for the full contribution, setting aside cash for a rainy day, or even purchasing a second home if desired, although second homes can become headaches very fast.
You have a great opportunity to strengthen your retirement savings if you decide to invest some or all of the cash balance. I also believe it makes sense to take some of the money and go on a nice family trip. Enjoy yourselves!
I also believe it makes sense to interview several financial planners/advisors to help you. This will be an excellent investment of your time. Just make sure they are "fee-only" advisors and not "sales-only" advisors. Advisors can help you define goals, map out an investment strategy, and help you with legacy planning (estate planning), and other financial goals.
In the end, you have a lot of financial flexibility to pay down/pay off debt, invest, and/or do both.
Good luck to you and your spouse!
I think you'd be surprised as to how often this question comes up. It has not only financial ramifications but psychological as well. As a fee-only financial advisor who sells no products nor received any commissions or referral fees, I believe that the size of your inheritance is such that paying off the mortgage should be the 1st step and then you can make determinations as to what to do with the remainder of the funds. The interest you're currently paying on your mortgage is extremely low and quite attractive. However, I can prove to you on paper that although the loss of the interest deduction will increase your income taxes a small amount, your after-tax cash flow greatly exceeds the amount of the tax. Among financial planners, the conflict typically arises by those who manage money because they typically charge 1% for the management of the funds and to the extent you remove funds from their portfolios, their fees are reduced. This is certainly not true of all planners but after 34 years in the industry, I run across the too often to not mention it. Don't underestimate the psychological advantage of having no mortgage on your home. Paying off 27 years early will allow you to sleep nights as will the inheritance. I sincerely hopes this helps and goo luck
This really depends on what type of investor you are. If you are a conservative investor, whose portfolio allocation will likely not earn more than 3.5% over the long run, or if you are nervous investor, and will likely pull money out of the market at the next down-turn, then you are better-off taking the sure thing by paying down your debt. However, if you are a moderate to aggressive long-term investor (5+ years at least), and can handle the ups and downs of the markets, without getting out at the wrong time (i.e. during the next significant downturn), then statistically speaking, you are likely to do much better than 3.5% in the market, so you should invest.
Let’s be debt-free first before building your wealth. The best way to honor the person who bequeathed you this windfall is to use it wisely. Besides mortgage, pay off any personal loans (student loans, credit card debts, etc.) you have. Then dedicate a 6-month of living expenses as your emergency fund and save in a checking account. If you don’t trust you have the discipline to do so when the account is too close by, put it in an online account, only for emergency. Christmas gifts, travel plans, new cars are not emergent occasions. I have seen way too many times how the inheritance blew away in a few months without a plan.
Once those priorities are taken care of, make an appointment to see a professional, preferably a CFP®, for the investment. She/he should suggest maxing out both of your 401ks or other work sponsored retirement plans. Depending on your earned income, the next thing is to fully your Roth IRAs or traditional IRAs. In case you have a high deductible health insurance plan, you can jump start the 2018 Health Savings Account (HSA). Not only you will save tax next Apr. 15, but also you’re on the path to fund your healthcare cost for retirement. If you have kids, start the 529 plans for them.
When you still have money left, take a vacation and invest the rest of the money in a taxable account with maximum tax efficiency and growth. Of course, your CFP® should customize a portfolio for your needs and goals. Best!