One day there may come a time when you receive a large lump sum payment. It could be a severance payment from work, the proceeds of an inheritance, a gift, an insurance payout or even a lottery win.
If this happens to you, you’ll have to face the decision of how best to deploy your newly acquired money.
For most people, it becomes a decision between investing in assets such as stocks or bonds, or paying off some or all of their mortgage.
Everybody’s situation is unique which means there is no single right answer.
However, by understanding the factors involved in making a decision, you can ensure you make the right decision tailored to your personal circumstances.
What is your attitude to debt?
For some people, they hate the very thought of being even $1 in debt. If you find yourself awake most nights stressing about your debt levels, it’s probably a simpler and better decision to simply pay off your mortgage.
Investing carries some risk so it requires you to first be comfortable with your current financial position. Otherwise you’ll be at risk of reacting emotionally when making investment decisions, which puts you and your money at risk of serious losses.
If you find you can stomach your current debt just fine, and you’re interested in getting the best return for your money, read on.
Can your cashflow support your mortgage repayments?
An important consideration is whether your cashflow is enough to pay your current mortgage repayments and other bills.
There is no use investing if you’re evicted from your home for falling behind on your mortgage payments.
Investing well requires patience and discipline. Often money is locked away for months or years so you can’t always count on being able to liquidate your investments to pay for your day-to-day needs.
Don’t fall into the trap of thinking you’ll invest and just pull out money when you need it. The market can crash at any time and if it happens when you desperately need to sell your investments, you may be forced into locking in large losses.
How disciplined are you with regards to investing?
Investing well is a rewarding, but also difficult and time-consuming activity. However not everyone has the willingness, let alone interest to do the work required.
The emotions involved can mean investors risk buying and selling at the wrong time, such as buying at the height of a market driven by euphoria, or selling at the bottom of a market during a panic.
As a result, for some people they’re simply better off not investing at all so it becomes a straightforward decision to pay off the mortgage.
If you’re willing and able to invest, or at least engage the services of a professional firm to do on your behalf, then it’s time to do the analysis that will determine where best to place your money.
What is your expected return on your money?
It may not seem like it but paying off a mortgage provides a return on your money in much the same way that an investment does.
The main difference is the timing – by paying off your mortgage, you’re making an immediate return. Whereas with an investment, you’re hoping for a return at some point in the future.
By comparing the return on your money of the two options, you can determine where to best place your lump sum, assuming your goal is to make the highest return on your money. Start by comparing your mortgage rate with the expected return on your investment.
For example, say your current mortgage rate is 4% per annum and you’re looking to invest in stocks.
You might look up the average gains of stocks over a long time period or refer to your past performance and determine that you can expect an average return of 9%.
When comparing the two figures, you are comparing a guaranteed 4% return (paying off the mortgage) with a potential 9% return (investing in stocks).
The reason you are receiving a guaranteed 4% return is because you will no longer have to pay interest on the lump sum amount that you’re using to pay off your mortgage.
In this scenario, you have a 5% gap between the return from investing and the return from paying off your mortgage. Depending on your risk tolerance levels, you may think the potential return on stocks are a better option.
But if the scenario changed and mortgage rates were at 7% for example, then the attractiveness of a potential 9% return on stocks diminishes rapidly.
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What Do You Think?
I asked the question on Twitter “If you had a spare 100k, would you pay off your mortgage or invest in the stock market?
Here are some of the best responses:
- Invest it and pay the mortgage off with the earnings. If you haven’t refinanced recently, that’s an option to lower your interest rate and potentially save thousands or more. Then you get the benefit of that savings WHILE paying off the mortgage with your market earnings.
- With rates at historic lows, 100% markets. Not necessarily long stock, but options etc.
- Mortgage, invest rest and future “mortgage” pymts
- If I had 5 plus years to retirement, stock market
- At these valuations 100% mortgage. Unless long short, then maybe stock market.
- Pay off your mortgage. Save thousands in interest, be debt free. Invest all future money
- 50 / 50, and the 50 in the market would be dollar cost averaged over the next 10 months
- I’d buy another house…use the rental income to help pay off the mortgage on your current home or invest in the stock market and while the house will increase in value over time.
Conclusion
There are many factors that go into the decision of whether to invest or pay off your mortgage when you receive a lump sump.
Provided you are comfortable with current debt levels, you can service your mortgage, and have the discipline, temperament and desire to invest, then by comparing the return on your money of both options you can determine the best approach for you.
Remember to consider your risk tolerance levels when making a decision and always work with a licensed and trusted financial advisor.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
