To someone with debt, receiving an inheritance can feel like winning the lottery. Occasionally, an heir doesn’t realize money will be coming her way and hasn’t planned for the windfall or thought about her options. Even those who do plan often realize that contemplating options for managing a potential windfall is quite different from making decisions once that money is in hand. There is a tendency to have a riskier approach to managing money until the windfall arrives in the bank account. Often, preservation instincts kick in and prevent people from taking action.
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Whether to use extra money to invest or pay off a mortgage is a common concern. Economists look at the numbers. If, after taxes, you can earn more in interest or appreciation by investing the funds than the amount of interest you’ll save by paying off a mortgage early, it is a better financial decision to invest rather than accelerate debt repayment. In its most simple approach, this ignores that the savings from paying off a mortgage early are guaranteed, and finding a rate that would beat the mortgage for investments could be very risky.
A shizennougyou reader offered the following question:
I am a single 53-year-old female with a 13-year-old daughter still at home. My mother passed away recently and I inherited a little over one hundred thousand dollars. My mortgage payoff is $41,000 and I have a second that is $14,000. My Lutheran Brotherhood rep tells me to invest all of it and to not pay off my mortgage since I only have seven more years on the loan at 5% interest. My gut tells me that I should pay off my mortgages to be totally debt free. Any thoughts would be greatly appreciated.
Nothing beats finding and working with a trusted financial planner when handling these questions. Being debt free is obviously important to this reader. Paying off debt is a burden. Every month, the work you do generates income already designated for someone else. Debt may not be slavery, but you will never fully own your income and the work you do to create that income until you are free to do what you want with all of your (after-tax) income.
The representative may have positioned 5% as being a low interest rate. It’s not a terrible mortgage interest rate, and you might even be benefiting from the home mortgage interest tax deduction. With only seven more years left in the loan, however, the biggest tax benefit is behind you because the majority of each mortgage payment goes to the principal of the loan rather than interest.
Can you beat 5% by investing the $100,000? It’s possible, but not guaranteed. A Lutheran representative should be aware of the risks; recently, Thrivent Financial for Lutherans was one of a select number of organizations that lost almost all of its investments due to a risky and possibly fraudulent investment scheme at J.P. Morgan. A proper mix of simple stock and bond index funds could beat 5% in the long run, but performance over shorter periods of time, like a decade, could be worse than the 5% you’d achieve by paying off the mortgage.
Even if you use $100,000 to pay off the remaining mortgage balances, you’ll still have $45,000 left, so it’s not an all-or-nothing question. Going further, if you strongly feel that investing is a better way to secure your financial future but you also feel strongly about reducing debt, you might be more comfortable using the windfall to pay off half of your remaining mortgage balance, leaving a larger remainder to invest. This would give you the benefit of exposure to stocks for the long-term while greatly reducing your monthly mortgage obligations or allowing yourself to finish paying off the mortgage a few years earlier than expected. If your daughter is 13 now, she may move out in five years. That could be a good time to downsize your living arrangement to save money, and when that happens, you may feel more comfortable if your house were to be completely paid off by then.
One other thing to consider is whether the representative you spoke to is also representing an organization like Thrivent Financial for Lutherans. This is a non-profit organization designed to help the community of Lutherans succeed financially through prudent investing. Due to his affiliation, he would suggest investing. Not only is it an acceptable choice and probably not a terrible decision, but his affiliation with the organization would certainly sway his advice towards the benefits he can provide. If you walk to a car dealership an ask a salesperson, “Should I buy a car or pay off my mortgage?” you can expect the car salesperson to suggest buying a car — from him.
This question is open to anyone who would like to comment. Should this reader use a $100,000 inheritance to pay off the remaining $55,000 balance on the 5% mortgages or invest the entire windfall?
Updated October 21, 2015 and originally published June 24, 2011.