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I Received an Inheritance (or Net Proceeds) Should I pay Down My Mortgage?

By
Mortgage and Lending with KJ Financial

When people get an inheritance one of the first things they want to do is to plunk it down on their mortgage.  Now that may be the best place to put that money, but it may not be too.  They need to have a consistent way to show them the smartest thing to do financially. (Note: for Real Estate Professionals you could easily replace "Inheritance" with "Net Proceeds" and come to similar conclusions.

That is where the Effective Percentage Rate (EPRTM) calculation comes in.  Thanks to our friends over at Kendall Todd we now have a consistent way to calculate the smartest financial way to allocate ANY cash windfall.

Here's the scenario: 

These folks have a $300,000 house that they owe $200,000 on their mortgage at 6.25%, they have 25 years left on their mortgage and they are in the 31% marginal tax bracket (25% Federal and 6% State).  They have $50,000 invested with a planner that has earned a 10 year average after tax annual return of 8%, they have two auto loans that they owe $27,000 on them they are paying $662 per month at an 8.25% interest rate, and they have 2 credit cards paying $380 per month on $9,500 and an interest rate of 14%.

They just got an $80,000 inheritance (or net proceeds from their previous house), they want to pay down their mortgage (put it all down on their new house) this would allow them to pay off their mortgage in 10 years 4 months instead of the 25 years now thus cutting off 14 years 8 months and saving them ($1,319.34 * 176 months = $232,203).

Is that the smartest thing for them to do from a financial standpoint?  You need to have a way to calculate whether this is the smartest way of doing it or not.  What we do is focus on breaking everything down to an Effective Percentage Rate (EPRTM).  This is the after tax cost of each debt.  Luckily the only real debt we can deduct is the mortgage so let's see how to calculate the EPRTM. (Some student loans have tax deductibility.)

The tax savings come at your marginal tax bracket which in our scenario is 31%.  So you would be able to deduct 31% of the 6.25% so multiply 6.25% by 31% you would save 1.94% so to calculate your EPRTM it is 6.25% minus 1.94% or 4.31%.  Your actual cost to borrow money is 4.31% so if you paid down your mortgage it saves you a guaranteed 4.31%.  How long would you stay with a financial planner that earned you 4.31% every year and it wasn't compounding?

What we do to decide the best allocation of our money is to compare the EPRTM of each debt and investment:

  • The mortgage has an EPRTM of 4.31% paying $1,319.34
  • The investment account has an EPRTM of 8%
  • The $27,000 of auto loans have an EPRTM of 8.25%
  • The $9,500 credit card EPRTM of 14%.

So the highest EPRTM is 14% for credit cards- so the first place we allocate the inheritance to is paying off the $9,500 leaving us $70,500 and freeing up $380 in cash flow.

Next highest EPRTM is the auto loans at 8.25% so we pay off $27,000 leaving us $43,500 and freeing up $662 in cash flow.

Next highest EPRTM is the investment account earning 8% so according to our formula we take the remaining $43,500 and put it into the investment account.  Plus we have freed up $1,042 in cash flow.  Where should that cash flow go to- the 8% investment or the 4.31% mortgage?

According to our optimization formula it goes to thehigher 8% investment so we have $43,000 and $1,042 a month going into the investment account and NOT the lower EPRTM mortgage.

Let's see where that leaves us.  In 3 years there is $96,858 in the new investment account, in 5 years there is $140,626, in 10 years there is $286,074.  We have enough to pay off the house in 6 years 4 months vs. 10 years 4 months when applying the entire inheritance towards the mortgage.

So at 10 years 4 months if we left the mortgage and kept investing where our EPRTM formula would tell us to invest.  The mortgage balance is $150,724 and the investment account is at $298,989 so following the EPRTM formula they are $147,265 ahead of plowing the inheritance into the house.

What if we kept following the formula out to 300 months, the remaining term on the mortgage, the investment balance would be $1,306,597? 

To be fair let's say when they paid off the mortgage at 10 years 4 months they invested the $1,319.34 at 8% for 176 months that investment account would have $439,377.

That is actually $867,220 less than using the EPRTM to make their financial decisions.  Which way is the smarter choice?

I know the argument would be that the auto loans and credit cards would be paid off so they could invest those dollars.  Experience tells a different story.  Until people realize how money works for and against them they will continue to go through life buying and financing new cars and will continue to keep a balance on their credit cards and they certainly wouldn't have the discipline to invest those dollars without the help of someone that understands money.

It pays for mortgage and real estate professionals to understand this when talking with our clients.  Don't our clients deserve it?

Comments (3)

John Klassen
M & T Bank - Kingston, NY

Great points. I went through this with my parents a few years ago. They had $30,000 left on a 5.5% loan. Only a few years left so they had paid the interest on it and were paying mostly principal. I encouraged them to take the $30,000 and plunk it into a CD and get a 3.50% rate of return which was better.

They kept the CD for two years took the interest and then sneaked behind my back to pay off the loan. At least they had the interest from the CD.

They understood the concept but could not overcome years of conditioning that told them to pay off the loan and burn the mortgage. My parents are from a generation that does not want debt and they have always lived that way. To their credit they are retired and living very well. I say conditioning becasue their decisions were based on a life experience that came from their parents.

We can use all of the logic in the world, it is smoke and mirrors to many people. The idea that mortgage debt is good, is strange to many people.

Excellent points.

Aug 24, 2007 07:47 AM
Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans

Kurt.... this is a 5....  It was explained very fluently....  it was not only easy to understand, but made a lot  of sense.  For us money geeks, we understand, but it was broken down for the average consumer. Good job.

jeff belonger

Aug 24, 2007 04:42 PM
Kurt Jackson
KJ Financial - Kansas City, MO

John,

Thanks for the kind words. A lot of folks from that generation make huge money mistakes and their fears are based on things that no longer exist- mortgages no longer have demand features so they only way the mortgage company can take your house is IF you don't make the payments and the reason that all the banks called those loans due in the late 20's was because the FDIC wasn't created and they needed the mortgages for liquid funds to give back to depositors. 

Jeff,

Thank you I have really been trying to get to where I can explain these concepts in terms that the normal everyday consumer can understand.  I get a lot of practice with my radio show.

Aug 25, 2007 10:06 AM