We’ve heard from a reader who’d like some investment advice — specifically, on whether he should use a recent inheritance of $30,000 to pay down his mortgage loan. This person has a 15-year mortgage with a balance of $200,000, at a 5 fixed interest rate.
If you also have a lump sum of cash to pay your mortgage, read on so you know what you should consider, before making the decision to liquidate your hard-earned money.
What does your money situation look like?
Before you think about using a financial windfall of any kind for investments, it’s a good time to take an inventory of your personal money situation and make sure you’ve already got all the financial essentials covered.
Is your budget for emergencies flush?
You must have an established emergency fund where you set aside money for unexpected expenses. A major car breakdown will not be in most common budgets, but they are pretty common occurrences. Similarly, we don’t plan or budget for out-of-town travel to family funerals, or minor medical emergencies, or natural disasters, but they do happen.
Is your retirement fund on track?
Your employer’s tax-free retirement savings plan is a priority. If your budget allows, you should max out your contributions, including a 401(k) (if your employer offers it), so you can receive for the company’s matching funds (free money!). Also be sure to fund to the max the health savings account provided at work.
How much credit card debt do you have?
Credit card debt is the most expensive, so pay down credit accounts and aim at maintaining a maximum 30 percent credit utilization ratio. In other words, keep your card balances at 30 percent of the total credit limit. If your total credit line is $10,000, owe no more than $3,000 (and spread the same ratio over multiple accounts). Auto loans and other personal financing can be expensive, too. Those big ticket purchases should made in cash if you’ve got it.
Paying down a current mortgage
If your financial inventory shows you’ve got the basics covered, then consider using your financial windfall to pay down your mortgage. As long as you don’t have any complications like mortgage prepayment penalties, you will shorten your loan term and reduce your total interest expense substantially by making an additional big principal payment.
Making an added $30,000 payment will not recast your scheduled monthly payments (meaning, they will stay the same as you’ve been paying). But more of each of those ensuing payments will be going towards the principal balance on the loan. And so, because of that lump sum payment, your loan payoff will advance by years. Considering this was only a 15-year mortgage to begin with, you could be cutting your loan term in half.
Paying down the mortgage vs. Other investments
So how does this compare to other possible investments for our reader’s $30,000? His mortgage interest rate is 5 percent — by using the lump sum to pay his mortgage, he’d be earning about four more points than if he were to dump that $30,000 into a bank’s savings account (currently, UFB Direct is offering 1.25 percent interest on their savings accounts). The choice to whittle down his mortgage with that lump sum is also safer than the stock market.
On the other hand, if our reader wanted to use that money to invest in something else, he could still pay down the mortgage by making smaller additional principal payments each month instead of writing that one big $30,000 check now. Adding $300 per month in principal prepayment will get him to about the same place as that $30,000 check, and allow a similar way to pay down the mortgage.
Why refinancing should also be considered
There is another mortgage payoff option for the $30,000 investment. If your plans are settled and you and your family expect to remain in your home for several years, you should consider refinancing into a new mortgage loan (that is, again, if there’s no prepayment penalty on the current loan). If you qualify for the best rates currently being quoted (see below), you’ll likely reduce the interest you’ll pay in the long run if you stay with a 15-year loan.
More importantly, if you didn’t have the 20 percent to put down on your original loan and you’ve been paying mortgage insurance (PMI), this could be the opportunity to free yourself from that expense. If you’ve made more than $10,000 in payments against the loan principal — or if the home has gained $10,000 or more in proven market value — you can combine that with your $30,000 for a 20 percent down payment. No more PMI!
When weighing whether to refinance, calculate how many months of lower payments it will take to recoup the closing costs of the new mortgage. Closing costs can amount to $2,000 on each $100,000 financed. Again, you have to plan to be in the house for a while for refinancing to make sense. So, the number of months it takes to recoup closing costs is a key calculation to do with the refinancing calculator.
Remember, true savings comes from reduced interest expense, not lower monthly mortgage payments. If you get a lower interest rate but extend the mortgage term, you can wind up spending more in interest in the long run. Substituting a mortgage that has 10 years remaining with a 30-year mortgage will result in higher interest expense over the life of the new loan.
You need to make sure you’re in a solid place financially, first, before you decide to invest that money into a lump sum mortgage payment.
Jeff is a licensed real estate agent in California and he specializes in home buying, mortgages, and debt, among other money topics. His work has appeared in Business Insider and Trulia.