Should I Use an Inheritance to Pay Off My Mortgage?

The following post was originally published on Wealthminder

One of our readers recently asked us the following question:  ” I’m going to be inheriting a substantial sum of money soon.  I also recently refinanced my mortgage into a 15 year 3.5% loan, so most of my payment is going to interest.  Should I use the inheritance to pay off my loan?”   Like most financial decisions, there is no one size fits all answer, but here are the key factors we would consider when making this decision.

Debt Levels

You should look at your current overall level of debt.  Do you have car loans, credit card balances, etc?  If so, you should pay these off before you consider paying off a home loan.  These types of debt typically come with higher rates of interest and that interest is not tax deductible.

Next, look  at the ratio of your monthly mortgage payment to your income.  Most experts will tell you that you should keep this ratio at 28 or less for mortgage payments and 36 or less for all of your debts combined.  If you are above those ratios, you may want to consider setting aside some of the inheritance to cover the gap.  You could pay down the mortgage, but unless you refinance, it won’t change your monthly payment.  You will simply decrease the number of years you have until the mortgage is paid off.  To see how the ratio works, here’s an example.  If your monthly mortgage payment is $2,500 and your income is $7,500, you ratio is 33.  To get that under 28, you would need a mortgage payment of $2,100.

Interest Rate and Investment Expectation

The lower your current interest rate, the less advantageous it is to pay off the loan rather than investing the inheritance.  Whether you itemize or not will also impact this answer.  Because mortgage interest is tax deductible, your effective interest rate is lower than the stated rate you are paying when you itemize.  For example, let’s say our reader pays 33% in state and federal taxes.  His effective mortgage rate is more like 2.35% due to the tax deduction.  From a purely financial perspective, if he believes he can make more than 2.35% on his money each year, he is better off investing the proceeds rather than paying down the mortgage.

Let’s use a simple example.  Say the loan is for $200,000 and we believe our portfolio will average 7% per year over the next 15 years.  Thus, we expect to make 7% – 2.35% = 4.65% more per year investing the proceeds.  After 15 years, before factoring in taxes, we would end up with almost $200,000 more.  Nothing to sneeze at for sure.

Our example loan had a fixed rate.  If the reader owned a variable rate loan instead, life becomes trickier.  Now you have to take in to account the possibility your interest rate will go up over time.  This adds one more risk factor to keeping the loan.  To figure out if you still come out ahead, you need to make assumptions about future interest rates and compare those numbers over time with your expected investment returns.

Credit Flexibility

Mortgage debt also has a couple of benefits that aren’t strictly about maximizing your long-term wealth.  The first is related to your credit score.  As you probably know, your credit score is a major factor in determining whether or not you get approved for future loans and the terms you receive.  While having too much debt can hurt your credit score, ironically, so can having too little.  A long history of having and consistently paying off your debts will help you secure future loans on favorable terms.

Another side benefit of keeping a mortgage is liquidity.  Assuming you don’t invest the inheritance in private equity or some other illiquid investment, keeping the loan gives you more short-term options if you need money quickly.  This flexibility can be advantageous if a crisis comes up.  Stocks and bonds can be readily sold, but selling a house or obtaining a new mortgage is not a quick process.  If you do decide to pay off the loan, I would suggest getting a home equity line of credit approved.  You should be able to find one with a low rate and no fees.  You don’t ever have to draw on it, but having it will come in handy as a fall-back if you need to raise cash in a hurry and don’t want to sell your other investments.

Tolerance for Risk

The final piece of the puzzle is your personal tolerance for risk.  Factored in to this are your age and when you plan to retire.  At the end of the day, debt is simply another risk factor.  While over any reasonable length of time, our reader should be able to generate better than a 2.35% annual return, there are no guarantees.  We could experience another 10 year period like 2000-2010 where investment results were minimal.  Paying off the debt is like getting a guaranteed 2.35% return.  Not earth shattering, but better than what short-term bonds have paid recently.

Wrapping It All Up

So, as you can hopefully see by now, reasonable people could come to different answers to our reader’s question depending on their personal situation and emotional make-up.  However, here are the key things we hope you take away.

  1. If you are about maximizing your wealth, and the interest rate on your mortgage is reasonable, you are probably better off investing the proceeds.
  2. There are benefits in terms of financial flexibility and ability to obtain future loans to having a mortgage.
  3. If you have trouble sleeping at night because you worry about having debt hanging over your head, or if you would keep a lot of money in cash (beyond an emergency fund), paying off the loan is probably right for you.

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