Homeowner's Best Use of $75K Inheritance?
Dear Dr. Don, I have come into some money from an inheritance and was wondering if I should use it to pay off my home or invest. I have 12 years and $72,303 left on a 5.375% mortgage. The inheritance is $75,000. I also have a home equity loan with a balance of $1,735 and a car loan with a balance of $4,400. There are no other loans outstanding. My credit score should be greater than 790.
Current interest rates are low, and the prospect of earning better than 5% in the stock market doesn't look good either. I am in my early 50s and would like to take the amount of the house note and put it into a Roth individual retirement account. Does this make sense?
Thanks, -- David Denouement
Dear David, You can get a new 15-year mortgage for 3%, so the relevant yardstick could be whether the after-tax return on your investment portfolio can beat the effective rate on a new mortgage. The table below shows that, before considering taxes and closing costs, you could save more than $12,000 by refinancing.
One of the other key variables in deciding whether to pay off the mortgage with the inheritance is what you plan to do with the money that is no longer going to the mortgage payment. People who have the financial discipline to invest that money can rebuild their investment accounts over time and pay themselves back instead of paying the lender. You do, however, lose the mortgage interest deduction on your income tax return.
The following table shows the approximate break-even point on investing your inheritance as a lump sum versus investing the original mortgage payment amounts over the next 12 years. At lower after-tax yields, the advantage swings toward prepaying the mortgage. At higher after-tax yields, the advantage swings toward not prepaying the mortgage.
Your idea of contributing to a Roth IRA is a good one if you believe you'll be in a higher tax bracket in retirement than you're in now. You also could justify it on the basis of having some tax diversification in your retirement portfolio. You would be contributing after-tax dollars, and qualified distributions out of the account are tax-free.
The Internal Revenue Service places income limits on the ability to contribute directly to a Roth IRA, but you can always contribute after-tax dollars to a traditional IRA and then convert it to a Roth IRA. Since you're older than 50, you also qualify for catch-up contributions. If you file a joint federal income tax return, you also could qualify to contribute monies to a spousal IRA.
The investment scenarios table (above) still works as an estimate if you're contributing to Roth IRAs, if you make the assumption that the lump-sum inheritance migrates to a Roth IRA over time, and that between catch-up contribution provisions and spousal IRA contributions, the monthly mortgage payments can all go toward a Roth IRA. What's key is that you don't have to subtract income taxes from your yields because you've invested in a Roth IRA.
The break-even yield is still approximately 4.7%. Expect to earn more, and you don't want to prepay the loan. Expect to earn less, and you'd want to prepay your mortgage and then start investing the money you've been spending on the monthly payments.
If you live in a community property state, you can keep your inheritance separately held, if that is your wish. If that is important to you, then using the inheritance to prepay your mortgage or to contribute to a spousal Roth IRA may not be in your interest. Consult with your attorney for advice, as needed, on keeping the inheritance separate from community property, if that's your situation.
I'll be the first to admit that I didn't dot every i or cross every t in this analysis. I played a little loose with the closing costs on the refinancing and the loss of the mortgage interest deduction on your taxes by ignoring both as decision variables.
If you decide to invest the inheritance, then you'd want to consider refinancing your mortgage to take advantage of today's lower rates. If you decide to prepay the mortgage with your inheritance, then you no longer would consider refinancing the property.
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