I've come into a large amount of money. Should I invest it or pay off my mortgage?
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?
A mortgage payment contains two aspects - the repayment of principal and the interest expense - that is charged by the financial institution holding your mortgage. The principal repayment goes towards the purchase price of the home and the interest is the expense charged for borrowing the money.
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.
The other side of the question is the investment. 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. 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.
What is 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 and during the financial crisis in 2008. 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.
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.
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.
I hate to be vague, but it depends on other debt, your goals, other risks, etc. For some, they just like to have it off their plate and have nothing to worry about. If it is an expensive debt with a high interest rate and you still have some liquidity, like an emergency fund, then pay it off. If you need to maintain some liquidity, then payoff a large chunk and keep the rest for an emergency fund. You want to make sure you are in a position to ride out any storm, you don’t want to be forced to sell something or takeout bad debt.
If it is cheap debt, and you have a good history of staying within a budget and the numbers look good for meeting your goals and growing assets, then keeping some of the debt might be an option.
The answer is usually somewhere in between. Just make sure you take an honest look at what you will spend and what your risks are.
Mark Struthers CFA, CFP®
Maybe you can address both.
In case you haven't already refinanced your mortgage to take advantage of current still low (but rising) interest rates, I would do that first to reduce the monthly payments on your mortgage. If you already did that, great, you should have an interest of less than 4% on your mortgage, plus take advantage of interest rate deductions if you itemize your taxes. That rate should be lower than what a diversified investment portfolio can achieve. The question is, can you manage it yourself or do you need an advisor to do it for you?
Numbers aside, it all depends on your personal goals and the life stage you are in. If closer to retirement, then the investment portfolio may not have enough time to appreciate and paying off the mortgage may be the best recommendation at that point, but if in your 30's, then investing would make more sense.