Each Monday we’re tackling one of your pressing personal finance questions by asking a handful of money experts for their advice. If you have a general question or money concern, or just want to talk about something PeFi-related, leave it in the comments or email me at firstname.lastname@example.org.
This week’s question comes from Ethan:
I’m about to inherit a little bit of money. I’m 45 and have a wife and two kids. This money is not enough to retire, but it’s enough to be life-changing. I was able to pay off my student loans, for example.
I will have enough to pay off my mortgage but I’m not sure if I should. If I do that it won’t wipe out my inheritance but it would be the bulk of the inheritance. My instinct tells me to think of my mortgage as a 4.1% loan and decide if I can do better with index funds. But I don’t know if there are other considerations to think about because mortgages are weird.
This is what individual experts have to say generally about an issue that affects each person differently—if you want personalized advice you should see a financial planner.
Mind the Interest Rates
What a problem to have! First things first: Do you have a sufficiently funded emergency fund, have you paid off any credit card debt and are your retirement contributions maxed out? If not, tackle those first. If you do, then things get interesting.
Essentially every expert I spoke to said the same thing: Don’t pay off your mortgage. If it’s fixed at 4.1 percent, you’re more likely to get a better return on a different investment. (Consider simply the cost of inflation on goods you use every day.)
And there are other things you’re missing. “For instance, if the reader is deducting the mortgage interest on their taxes, then their effective interest rate is going to be lower than 4.1 percent,” says Parker Trasborg, a Virginia-based Certified Financial Planner. So if you’re in the 24 percent tax bracket, for example, than the true cost of the loan is 3.11 percent, per Trasborg, making it even less pressing to focus on paying down. “We may never seen mortgage rates that low in our lifetime ever again,” says Ashley Foster, a Texas-based financial planner.
You don’t want to pay off the low interest mortgage and forgo potential higher earnings. According to Vanguard, a portfolio made up of 70 percent stocks and 30 percent bonds averaged an 9.1 percent annual return from 1926-2016. While there’s no guarantee that that trend will continue, you’re more likely to get more bang for your buck if you invest your inheritance in low-cost index funds.
“Index funds tend to be more tax efficient since so there’s less of a tax drag, so investing the money in mathematical terms is likely the better bet,” says Carl Holubowich, a Washington D.C.-based Certified Financial Planner. “Investing the money also gives you more liquidity, meaning you can easily sell and get access to cash if needed. If you pay off the mortgage then more of your net worth is tied up in home equity, and to tap into it you either have to sell the house or take out a loan.” If you do choose to invest, your allocation should be fairly aggressive, given your age.
That said, it does come down to your priorities. “I tell folks that the math is irrefutable that having a long term fixed mortgage makes economic sense, but spreadsheets don’t have to sleep at night,” says John Scherer, a Certified Financial Planner based in Wisconsin. “The goal of being smart with your money is to achieve financial peace of mind, not to end up with the biggest pile of dough. So if the worst decision someone makes is to pay off their mortgage…but it helps them sleep at night, that’s what they should do.”
But there may be a middle ground. Kathleen Campbell, a Registered Investment Advisor in Fort Meyers, Fla, suggests talking to your lender about paying off part of the mortgage, which will allow you to “re-amortize” the balance if it’s a sizable chunk. This will reduce your monthly payments going forward.
“For instance, if their original mortgage was for $300,000, then their payments are based on $300,000 principal,” says Campbell. “But if they pay off $100,000 and their new balance is $200,000 or less, then a re-amortization would use that amount as the principal and the new payments would be much less.”
There’s no guarantee that that will work, however. Here are some other options.
You may also consider adding some money to your children’s college funds if you plan to help them pay for their education. “He mentions that he has two kids, so my first recommendation would be to put part of the money in a good 529 plan,” says Campbell. “Depending on what state they live in, their state might even provide a state tax break for 529 plan contributions. If the state doesn’t have a tax break, then they should find the best and least expensive plan.”
You can find a list of the best and worst plans here. Campbell highlights the Utah Education Savings Plan (called the “My 529″ plan) as a standout.
And you could always max out your contribution to your company retirement plan, using the inheritance money to offset the cash flow, and max out IRA contributions for you and your spouse.
Craig Cowles, a Texas-based Certified Financial Planner, says that cash is king. There may come a time when you have a tax bill or unexpected medical bills. “They can easily zap you of $10,000 for a one time event,” says Cowles. So keeping some of it liquid is certainly a consideration.
One more thing: Commingling your inheritance with assets that both you and your spouse have ownership in could put you at risk of losing it in the case of a divorce or if your spouse has a civil judgement against them one day, depending on the state. “You may also want to speak to an estate planning attorney about how to protect that money,” says Brad Wright, a Massachusetts-based Certified Financial Planner. Just to be on the safe side.