You've received a large lump sum of cash and want to put it to use. Should you pay off your mortgage or invest that money? There is no simple answer to this question as it depends on a number of key factors, namely the aspects or criteria of your mortgage and investments. By illustrating these factors you'll be better armed to make this choice.

The question boils down to: Which of these - the investment or the mortgage repayment - takes greater advantage of the money you received?

Key Takeaways

  • If you've received a windfall of cash and have a mortgage, it may be tempting to use that money to pay off the mortgage early and live debt-free.
  • While this may sound like a smart strategy, it could also be quite conservative since mortgage interest can be tax-deductible and mortgage interest rates tend to be relatively low.
  • Using that money to invest in the market can generate higher returns than the interest rate paid each year on the home loan, but markets also come with the risk of losses or underperformance.

Paying off the Mortgage

A mortgage payment is composed of two parts: the repayment of principal and the interest expense that is charged by the financial institution holding your mortgage. The principal repayment goes towards the paying down the original purchase price of the home and the interest is the expense charged for borrowing the money over time.

Let's assume you received a lump-sum payment of $50,000, and you have 10 years left on your mortgage. If you were to pay for it today it'd cost you $50,000 in principal. If you were to continue to make monthly payments until the end of the mortgage, you'd end up paying an extra $15,000 in interest payments (the amount of interest you pay is dependent on the mortgage rate). Using that $50,000 to pay it off today brings a savings of $15,000 in future interest expenses.

What you need to consider is the interest rate on your mortgage. If it is a fixed-rate loan, is that rate higher than you can afford? Could you benefit from reducing the amount owed at such high interest? If the mortgage is adjustable, do you think interest rates are going to rise in the future making your monthly costs more expensive?

Remember that mortgage interest may be tax deductible for you, so that if you are paying 5% on the mortgage, your net interest payment may be closer to 3.75% if you're in the 25% income tax bracket.

Investing in the Market

The other side of the question is the investment decision. There are several factors to weigh when evaluating an investment. The first is its expected return - is it so attractive, with high expectations of growth, or is it in the more conservative mutual funds or bonds category? The more attractive the investment, the more likely you'll invest the money.

If, for example, the investment is expected to earn 10% each year for the next 10 years - the same length as your mortgage - the $50,000 would turn into nearly $130,000. In this case, you'd want to put the money into the investment and make regular payments on the mortgage since the $15,000 you'd pay in interest payments would still leave you with $115,000 in profit.

However, a 10% return is not a very easy goal to achieve these days. At 5%, your $50,000 investment would turn into a little over $81,000 by the end of the 10 years. The higher the investment return, the more likely you are to invest than paying down the mortgage - but make note that these returns are never guaranteed.

Ultimately, if you think that the investment will give you a net after-tax return that is higher than your net interest cost on your mortgage, it could be wiser to invest.

Risk Tolerance

What is crucially important to your decision making is knowing your risk tolerance - the more risk you take, the higher your expected return. The stock market does provide exciting returns but it can also devastate like it did for many investors in 2000 when the dotcom bubble burst. If you can't handle the risk of losing a large percentage of your portfolio while still having to pay off your mortgage, it may be safer for you to just pay off the mortgage and save the $15,000.

What the Experts Have to Say:

Advisor Insight

Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN

A lot depends on the nature of the mortgage and your other assets. If it is expensive debt (that is, with a high interest rate) and you already have some liquid assets, like an emergency fund, then pay it off. If it is cheap debt (a low interest rate), and you have a good history of staying within a budget, then maintaining the mortgage and investing might be an option.

Some people’s instinct is just to get all debt off their plate, but you want to make sure you always have ready funds on hand to ride out a financial storm. So the best course is usually somewhere in between: If you need some liquidity, then pay off a large chunk of the debt, and keep the rest for emergencies and investments. Just make sure you take an honest look at what you will spend and what your risks are.