Recently, Tom and Raza inherited $250,000 from her parents. This unexpected windfall sparked debates on how best to use these funds. They wrestled between paying off their $231,000 mortgage OR investing for their future. Completely frustrated and at an impasse, they let the money sit for a few months, and then realized earning nothing was not the honorable way to value Raza’s parents’ hard-earned gift. They reached out to us for insight. We receive this question quite often, almost weekly, so we are happy to help.
While the question, payoff the mortgage or invest the money seems straightforward, lots of factors influence the decision process. Before exploring the decision process, let’s go over some lingo.
DEBT
This weird and oddly spelled word evokes such a variety of responses. Upon hearing the word debt, we leap to the conclusion that it is BAD - Avoid it at all costs!! We think liability, weighed-down, shackles and obligation. That might not always be the case.
The analogy “debt is like fire”, is quite useful in providing perspective. Fire is a cozy blanket when we sit and bask in it glow as it warms us up on a cold night and a useful tool when we roast marshmallows or hotdogs. Comparatively, fire blazing uncontrolled may be harmful, painful and destructive. Debt is no different.
On the positive side, we use debt for large purchase: a home, pursuing education, starting a business. Unfortunately, debt can get us into trouble when we overspend our budget, or consistently rollover high interest credit cards.
INTEREST RATE
The cost you pay to borrow money. When you purchase a home, car or boat, the lender assesses your eligibility for a loan. They look at how risky it is to loan you money. They review your credit score, current debt obligations, income, assets and other factors to determine what kind of a risk you are. The higher the risk, the higher your interest rate. Higher interest rates mean you are paying more to borrow money.
INFLATION
The buying power of your money over time. A dollar in 1990 could purchase more than a dollar in 2022. What a dollar is worth in goods changes over time.
RETURN ON INVESTMENT
When you place money in an account, the return is how much the money will grow or possibly shrink over time. In a bank, you receive interest in a savings account. When you invest in the stock market you receive a potential growth rate based on the risk you choose. The growth rate (return) is based over time. For a loan, the bank determines how risky you are. When you invest, you determine your comfort level with regard to risk factors. Investing carries risk. We are all aware that the S&P 500 is NOT a straight line up. It moves up and down, but over time it has moved in a positive direction.
THOUGHT PROCESS
Emotional versus Logical
So in looking at Tom and Raza’s issue, in the simplest of terms they are weighing whether to pay off their 3.5% mortgage so they no longer pay the bank $8,085 in interest annually or invest their dollars at a conservative growth rate of 5% that translates into a potential $11,550 in growth per year.
Raza loves the idea of being debt-free. Imagine having no debt. Sounds great! You freed up your cash flow and have limited obligations to others. How important is this? How much weight do you place on being debt-free? How stressful is debt for you? Raza was relieved to imagine no monthly mortgage payment and knowing that she and Tom own every inch of their home. She also was averse to risking money in the stock market.
Tom sees the benefit of investing. He understands that his projected investment return is greater than the 3.5% mortgage interest rate. He sees a bigger picture where the interest payment on the house loan decreases over time and his investment has the potential to grow and, from his experience, he anticipates that over the long-term he will see his investments growth potential.
Armed with this information, Raza and Tom can have an open discussion regarding debt versus investment. As with most decisions, there is an analytical/logical choice mixed with an emotional component. Our job is to support our clients and balance the two sides of this choice.
So how do we put this to use in your life? Because every individual or family has different values or risk tolerances, we encourage clients to consider what interest rate is their “line in the sand” when it comes to paying off loans versus investing. For some, the freedom of being debt free is priceless and they attack all debts before investing. For others, they are riskier by nature and will pay the minimum payment on debts and invest the rest if the debt interest rate is below 5%. We encourage you to develop the most important goal: HAVE A PLAN.
Any opinions are those of Colin Talbot and Anne Holub and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Past performance may not be indicative of future results. Investing involves risk and investors may incur a profit or a loss. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
