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Mar 7 2011 12:00AM

Question

I’m about to receive a substantial estate gift. I am 52 years old. Should I pay off my home loan or would I do better investing the money? I have 10 years left the mortgage and it has 4.5 percent interest rate.

Answer

FPA member Delia Fernandez, MBA, CFP®, of Fernandez Financial Advisory LLC said the following:

“A financial windfall can be a wonderful boost to someone’s financial plan, but it has to be used carefully. As you point out, it can be difficult to decide how to use the money.

“Without more details on your overall situation, here are some things to think about in priority order on how to allocate the funds.

  1. Do you have an emergency fund? This should amount to three to six months of expenses. You might need more if your job is uncertain or if you are self-employed.
  2. Are there any major expenses that you expect in the next one to three years? Include major maintenance and repairs to the house, replacing a car or a major vacation. If so, you should earmark some funds for those purposes.
  3. College. If you need to send children to college, do be sure to put aside funds for that purpose.
  4. Debt. Do you have any credit card or other debt that has a higher interest rate than your home? If so, pay that off first. But be clear how you got there. If you pay that debt off and then just run up the debt again, you’ve wasted the money without solving the spending problem.
  5. Retirement. Are you saving the maximum in your employer’s retirement plan? You especially want to do this up to the amount of an employer’s matching funds. If you are on track to retire, great (you may want to check in with a planner to review that). If not, take a look at using other retirement vehicles such as Individual Retirement Accounts (IRAs) or Roth IRAs, if you qualify, to boost your retirement plans.
  6. Pay off the house. If you have items one through five on track, then many people enjoy the freedom of having their house paid off. But keep in mind that 4.5 percent is a great interest rate, and at a 25 percent marginal Federal tax rate is the equivalent of 3.375 percent, which is really low. So you may not want to pay it off all at once, but you certainly could make extra payments to be sure it’s paid off when you retire.
  7. Investments. It’s great to have money invested outside of a retirement account. There can be some tax advantages, since right now long-term growth and dividends are taxed at a lower tax rate than when you remove funds from a 401(k) or IRA. But tax laws can change.
    “Other things to think about are contributions to charity or gifts to family. And don’t forget to set aside some money to treat yourself, especially if you inherited funds due to the death of a loved one. Consider taking a nice trip or buying something special to remember them by.”

For his part, FPA member Daniel Sands, CFP®, a registered representative at Geneos Wealth Management and a vice president at Silversage Advisors, said the following:

“Without knowing your specific financial circumstances, I would suggest you balance two considerations in making the decision on paying off your mortgage with your estate gift.

“The first thing to consider is cash flow. Our experience has shown clients with lower expenses (i.e. no mortgage payment) heading into retirement are more likely to meet their retirement goals because they demand less income from their portfolios. You should ask yourself when you plan to retire and what your cash flow and income sources will look like in retirement. Since you are 52 and on track to pay off your mortgage by 62, you could still be on track for reduce expenses in retirement without needing to commit the capital to the mortgage today.

“The other factor to evaluate is liquidity. Your home is going to appreciate or depreciate regardless of whether you pay off the mortgage or not. Sometimes people incorrectly think paying off their mortgage is investing in their home, but you would receive that capital gain or loss regardless of the amount of mortgage you owe. Once you pay off the mortgage, it will cost you money to access that capital again. To use the monies, you will be looking at another mortgage, equity line of credit, reverse mortgage (though you will need to be 62) or selling the property. All these have costs associated with them. While interest rates are historically low now, they might not be attractive in the future. Assuming your 4.5 percent interest rate is fixed, this is an attractive rate and offers a relatively low hurdle rate if you choose another option with the gift.

“You will want to evaluate the impact paying off the mortgage will have on your taxes. The interest on your current loan may allow you to itemize your deductions and the lack of interest could force you into a standard deduction.

“Debt is a very personal feeling for most people and how you feel about owing debt is worth bearing in mind. Some people understand it is a form of leverage and feel comfortable using it; others lose sleep at night if they owe anyone else a dime. How you personally feel about debt should not be ignored. You are on a reasonable and prudent track to pay off your mortgage by age 62, if this happens to be near the date you plan to retire, I would give heavy thought towards maintaining your liquidity and using it for other investment or business purposes. Paying off the mortgage will save you on interest costs, but it does not necessarily ‘make’ you more money on your home.

“I would suggest you evaluate your current and future cash flows to see how these match up with your goals. Then consider how liquidity of the monies plays into these same goals. Balance in the impact of your taxes and how you personally feel about debt and you should be in a good place to make a prudent and informed decision.”

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