I inherited $400k. Is it better to pay off my $400k mortgage, or invest the money? (question from Quora).

Here’s the back-story — a Quora user asked this question, and stated the following:

I’m 30 years old and bought a house a year ago, valued at ~750k on Zillow, and I owe $400k (4.25% interest) on it.

I’ve always liked the idea of living mortgage free, but is it worth paying off the lower interest rate (4.25%) that also gives me a tax break (for itemized taxes) vs. putting the money into investment (6% + return)?

It feels riskier to invest the money even if it does give a higher return….what’s the smart move?

(I have no other car/student/credit card debt and do have an emergency fund of 1 year living expenses saved and work full-time.)

My answer:

Others here have given good answers — and strangely, despite their recommendations being opposite, I am a fan of the posts by Masa Kawa and M. Taylor. Both make good points.

It’s a tough decision, but there are pros and cons to each approach… and in my mind, the decision of which choice is “right” depends not solely on the numbers — but on your future goals, your mindset, and a few other factors.

Let’s get started!

Step 1: Take a Minute to Consider Each Question Below

1. What is your outlook on your own financial future? You mention that you have a one year emergency fund and that you work full-time. That’s a great start! Still, do you think that there is a good chance that you’ll need to tap into the $400k in cash any time soon? How stable is your job, and if you lost it, what are your prospects for finding another job quickly?
2. If you had $400k in cash, how likely are you to spend it poorly, or invest it poorly? In other words, is it “safer” being tied up in your house?
3. Sanity check to help confirm the validity of your answers to the above two questions — what is your track record in terms of financial responsibility? You have a 1 year emergency fund and a full-time job — and again, that is a great start and indicates to me that you’ve been responsible, but only you can answer this question.
4. What are your plans for the future? Some of the questions below may seem unrelated, but bear with me — you’ll see how they play into your decision:
   1. How long do you think you’ll live in this house?
   2. Do you ever plan to start your own business, or make a non-traditional investment?
   3. Do you envision your salary going up? Down? Or staying the same? Do you think you’ll remain in the same line of work, or that you may be seeking a change in a few years?
5. Psychologically, does one approach just “feel” right? Some people hate making a mortgage payment, and even if it’s not the best financial move, they love knowing that their house is paid off… Think about what feels right — but before making a decision, read through the rest of this post and think through every aspect of the decision.

Step 2: Consider The Options

Investing
Comparing the potential return on investment of paying off your house vs. investing in something else, it’s admittedly a tough call. Sure, the S&P 500 has shown about 10% annual returns since 1928, which, adjusted for inflation, comes down to about 7%. That sounds great — but once you tack on tax liabilities, depending on your tax bracket and your trading strategy, you may lose another 20% or more on taxes, bringing you around 5.6% or less.

While no one can truly call the market, many believe that because we’ve been in a bull market for so long, we are due for a correction soon. It’s impossible to truly know when or if a correction will take place — however, history has shown us that there are no guarantees — and if you will need access to the $400k any time soon, it may not be smart to invest it all in the stock market. Had you done so just before the 2008–2009 crash, you may have lost up to 54% of your investment over the course of 17 months. It’s hard to get timing right.

You have a one year emergency fund — if you believe that you could get by without any salary for one year, and you don’t expect to lose your source of income any time soon, you may be okay with taking a longer-term approach. If you have a 7–10 year time horizon, your returns over time will likely exceed the cost of mortgage interest payments. To further reduce risk and overall volatility, consider consulting a financial advisor, using a “Robo-Advisor” like WealthFront or Betterment, or using a diversified portfolio strategy. Also, don’t invest in individual stocks — instead rely on low-fee index funds and ETFs.

There are too many investment options to list here — you could invest in real estate, municipal bonds, or even your own business idea. These investments have varying levels of risk and return. For now, I’m focusing on what I’ll call a standard/diversified investment strategy. This does not mean investing in your best friend’s latest and greatest business idea after his last 12 have failed.

Advantages to Investing (assuming a fairly “standard” and diversified investment approach):

1. Likely to earn higher returns over time than you would simply by paying off your house.
2. Potential to use dividends from investing to pay a portion of your monthly mortgage payment, assuming you choose not reinvest them. This reduces the amount of money that has to leave your bank account each month — and there’s an underlying asset (stock) that will hopefully continue to grow over time.
3. More liquidity. Even if you invest the entire $400k into the market, if you need to pull some money out, most of the investments I’m talking about above will allow you to do so (sometimes at the expense of paying standard income tax vs. long term capital gains tax). While you could end up having to pull money out during a down market, meaning that you’ve now lost money, at least you can get to your money without asking the bank for a loan or to refinance your house (which is what you might need to do if you used the $400k to pay off your house). And if you’re really in a situation where you need the money badly, it’s probably going to be harder to get a loan from the bank at that point (i.e. your credit may have taken a dip, or you may not have a salary or regular income).

Disadvantages to Investing:

1. Potentially more risk exposure — though your house could dip in value as well, so it’s hard to say whether or not you’re really subject to more risk.
2. Could be difficult emotionally to handle occasional losses and dips in the market. If you’re the type of person who can “set it and forget it” (hopefully relying on an advisor or a robo-advisor), then you’ll probably be ok.
3. You won’t have the peace of mind of knowing that your house is completely paid off — but your investment should hopefully bring you a different type of peace of mind, and more liquidity.

Paying off the House

By paying off the house, you avoid paying 4.25% in mortgage interest. Yay! But as M. Taylor pointed out, after tax savings (mortgage interest deduction), that is likely closer to 3.25%

Now that you’ve paid it off, your money is tied up in the house. The house is a good investment too, right? Not so fast — it may be a bad investment. Over 105 years, home prices rose by under 1% per year.

And here’s food for thought… your house is a great form of collateral to secure a loan. As a business owner who has had to take out small business loans, I can say that it is a bit more difficult to borrow money from a bank without something as straightforward as a house to use as collateral against the loan. Business loans usually incur a higher interest rate and it is difficult or impossible to get a 30 year fixed style loan for a small business.

If you ever plan on starting a business where you may need some extra capital to start the business or grow the business, you may be better off keeping this money and using some of it for that purpose. There’s still risk in using money for a new business endeavor, any way you cut it (as a small business owner, you’d be personally liable to pay it back), but why not take advantage of the beneficial terms that you’ll get on a mortgage loan vs. a small business loan?

On the plus side, when you pay off a house, it’s a “done deal” and you know you can live there without monthly mortgage payments. It may not be the best investment, but it’s a tangible asset and it’s nice to live in the house and not feel like you owe anyone money. On the other hand, keep in mind that many billionaires and other wealthy individuals have in some way used leverage to get there — that is, they have used the money of others (such as a bank) to get there. $400k invested within a brokerage account has a much larger potential upside (and arguably higher risk, depending on how you handle the money) than paying off your mortgage. Even $400k left in cash, if used creatively when the time comes, could yield higher returns than you’d probably see by paying off your house. For example — in the event of a major stock market crash or other correction, you could decide to invest in the stock market then if you’re not comfortable doing so now. Or you could use that money to help you to start your own business when you are ready.

Advantages to paying off the mortgage:

1. Peace of mind — the knowledge that you don’t owe the bank anything.
2. As long as you maintain homeowner’s insurance, the knowledge that your money is now invested in an asset that is truly “not going anywhere.” It may decline to some extent in value, but the majority of your principal is safe. It’s worth noting that even if the value of your house declines, you’d still have to pay back the mortgage (unless you want the bank to foreclose on your house). So, investment gains or losses on the house are not impacted by the fact that you hold a mortgage (other than the mortgage interest paid).
3. If you don’t have the best track record with spending money or making investments, paying off the house will tie up this money and prevent you from spending it or investing it foolishly.

Disadvantages to paying off the mortgage:

1. You lose flexibility to invest in something that might have higher yields.
2. That cash is no longer liquid, or easy to access.
3. You’re no longer leveraging one of the easiest ways for a homeowner to borrow money — which, when you think about it, can be used for whatever you want to use it for. You have $400k and could pay off your loan. By not doing it, you are leveraging your house to get a very low-cost loan, presumably with a 30-year payback. Good luck getting a business loan like that.
4. Here’s one that most people don’t think of — but you’ll no longer have the bank on your side. Right now, they are working to protect their asset/collateral. This means that they’ll make sure that you have the proper type of homeowner’s insurance policy in place, that your taxes are paid. This may not be extremely valuable, but it’s kind of nice to have someone else keeping an eye on things.

Finalizing Your Decision

Here are some decision-making criteria that would apply to the general public:

Pay Off The House If…

1. First and foremost — you have an emergency fund that will last you at least one year and cover all regular expenses, and then some.
2. It is something that you feel you need to do psychologically to free yourself from the burden of the mortgage — as long as you realize that you could probably see greater returns and have more liquidity by putting your money elsewhere.
3. You have a poor track record with investments and/or spending habits, and you’d rather know that you can’t touch the money.
4. You don’t have aspirations over the next few years to start a business, take a work sabbatical, or make other investments.

Don’t Pay Off The House If…

1. You don’t have an emergency fund that will last you at least a year — in which case, consider taking a portion of the money and investing in something very low in risk (CDs or high-interest checking accounts are safest, but also currently offer almost non-existent returns — consider municipal bonds as well).
2. You may want to take a break from work for a while, switch jobs, start a business, or basically “step into the unknown” in any way in the near future. Some extra cash or other liquid assets will be immensely useful to you.
3. You want to see the best return on your investment over a medium-long time horizon. Note that it is true that more returns usually mean more risk, however, history has shown us that over a long period of time, it’s extremely likely that you’ll do better by putting your money into other investments.

Keep In Mind A Few “Hybrid” Choices

1. Consider paying off some principal on your mortgage, which will effectively reduce the interest that you pay over time. You could take $200,000 and pay off some of your principal to put you in a better place.
2. If it’s the monthly mortgage payment that you don’t like, work with a financial advisor to craft a strategy to use dividend-paying stocks or other investments with ongoing coupons or dividends to put toward you monthly mortgage payment. Or do it yourself by investing in Dividend ETFs (note that I do recommend doing thorough research or working with a professional).
3. Realize that you’re not limited to any one strategy. You could pay down $100k of your principal, put an extra $25k into your emergency fund, and put the rest into equities (stock and stock-like) investments (or some combination of bonds and equities).

Knowing Your Situation…

To recap your situation, it sounds as though you are in a pretty good place financially. You’ve managed to save enough to last you a year — and not everyone is capable of doing this!

Knowing your situation, I would advise against paying off the mortgage. If you have a long-term time horizon, you’ll see better returns elsewhere, and, perhaps more importantly, you’ll have a lot more flexibility. That said, you know yourself better than I do — the caveat that I would add here is that if you do not pay off your house, be very careful with the money and think long and hard about your goals before you decide what to do with it.

If there is a nagging feeling that you should pay off the house, look at where that is coming from. If you truly don’t trust yourself with the money, that’s one thing (and paying off the house may be best). If you think that it’s the best place to put your money, take some time to challenge that assumption.