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May 2 2011 12:00AM

Question


I am a 40-year-old divorced woman with no children earning $125,000 per year. I have about $300,000 in investments for retirement. My house is worth $550,000 and I owe $205,000. I just received an inheritance of $200,000. Do I pay off my house? I have no other debts beside my mortgage. I am in year seven of a variable rate mortgage that now has a 3.5 percent interest rate.

Answer


"Deciding to pay of your mortgage will depend on several financial and personal considerations," said FPA member Jennie Fierstein, CFP®, of J. Fierstein Financial Advisors. “Compared to other debt, carrying a mortgage is regarded as an acceptable form of debt.”

Fierstein suggests you think about the following factors when evaluating your options:

  • You have no other debt. Analysis: You manage your money well, and/or you have an aversion to debt.
  • You are age 40 with retirement savings. Analysis: At what age do you plan to retire, what is your current savings rate, and what type of lifestyle are you projecting once retired? 
  • You now hold a variable rate mortgage. Analysis: A 3.5 percent rate is good rate; Is there a contingency plan when interest rates begin to rise? Is this year seven of a 15-, or 25-, or 30-year mortgage?
  • Goals and risk tolerance. Analysis: You indicated no goals other than retirement or your comfort level with investing. Also, no mention was made about your job security or keeping an emergency fund.

Prior to your making a final decision, Fierstein suggests you do the following:

  1. Run the numbers to determine if based on your savings rate, when you plan to retire, and what your retirement income need will be. Ask yourself: Are you on track for retirement?
  2. Evaluate your tolerance for risk, your portfolio, and an acceptable yet realistic rate of return through retirement.

"If you feel you are comfortably on track for your retirement, maintain good job security, and have three to six months of expenses put aside in savings in the event of an emergency, then paying off your mortgage would be a sound financial decision,” said Fierstein. “Theoretically, you’d be investing at a 3.5 percent rate of return. In this case, depending on your tax situation, you may be giving up the tax deduction of your mortgage interest.

“If, on the other hand, you should need to access those assets in the future and are comfortable investing, you would be maintaining a level of flexibility by not tying the money up in your house. Please keep in mind along with the opportunity of potential return comes a greater potential for risk. In this case, you should also consider locking in a fixed mortgage rate.

“It is always advisable to consult a tax advisor regarding the tax consequences and impact on your tax return before making any final decisions.”

“With the limited information I have that was stated in your question, I would not recommend paying off the mortgage with the inheritance,” said FPA member Jennifer Simes, CFP®, of Carl P. Sherr & Co., LLC. “This is assuming that based on your current payments, your mortgage is planned to be paid off by your expected retirement date. Given that rates are still low, I would consider refinancing your mortgage to a fixed rate mortgage. If possible with your cash flow, a 15- or 20-year mortgage would be ideal. Most likely the rate will be a little higher than what you are paying, but you lock in the rate until the maturity of the loan. Also, I recommend that you formulate a long-term investment plan for the inheritance along with the retirement assets and be sure to have enough liquid cash set aside in savings for six months of expenses.” 

Another planner, FPA member Daniel J. Galli, CFP®, of Daniel J. Galli & Associates, said, “it’s not possible to definitely answer this question without additional information such as your investment risk tolerance, retirement age goals, how long you plan to live in the house and other data. However, I can outline two sides of the issue and that may be helpful enough for you.

“Paying off the mortgage provides emotional peace of mind. Having no debt on your home can be a very comfortable feeling. It also frees up monthly payments that can be re-directed to retirement savings through an employer plan like a 401(k) or 403(b). It also will save you paying interest on the outstanding loan balance. And lastly, it eliminates concerns about how rising interest rates in the future could cause your monthly mortgage payment to increase.

“Not paying off the mortgage also has some advantages. Your current cost of borrowing this money is very low. Additionally, you can deduct the interest on the mortgage further reducing its actual cost. The inheritance money can be saved and will grow through interest. However, here’s where today’s very low interest rate environment works against you. The potential earnings on this money would be very low, perhaps less than one percent. However, you still would have access to this money if you needed it. Paying off the mortgage removes the potential use of this money unless you sell your house or borrow against it.

“I would be concerned about the variable rate mortgage. Unless you plan on selling the house in the next few years, you face significant interest rate risk. If rates rise, the cost of the mortgage will rise. This could become a problem. Having the money to pay off the mortgage helps to alleviate this danger.

“Another course of action that you can consider to offset this interest rate risk is to re-finance the mortgage to a 20-, 25-or 30-year fixed mortgage. The rates right now are close to historic lows. However, they will be higher than you are now paying — perhaps around five percent. However, the new rate would be guaranteed not to increase for the life of the mortgage. Then you could work in investing the inheritance money to earn more than the net cost of the mortgage. This won’t be easy today, but if interest rates rise, you could find yourself in a situation where your invested money is earning more than the fixed interest rate mortgage is costing you.

“Again, without knowing more I can’t give a definitive answer, but these are the considerations.”

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