Ask Money

Pay off mortgage with inheritance

Chris Farrell Oct 18, 2010

Question: In the past eight months both my mother and grandmother passed away. Due to my mother’s passing I stand to inherit from my grandmother directly at this time. The amount is between $180-240,000 depending on the sale of a condo and other estate things. I am a married student with a young son. We purchased our first home in 2009 with a 6% 30 year mortgage. We owe just over $90,000 on the house and near $15,000 jointly in student loans. My husband and I are both going into education and have zero savings at this time. We do not have credit cards at all and the only debt we carry is listed above. Any inheritance from my mother’s estate will hold until my father passes away; hopefully in many more years!

I would like to set some money into a safe place for my son’s future. The stock market is not something I want to get involved in and we want to use the money to the best advantage and with the least tax penalties.

I will be out of school in 2011 but am considering extended graduate work. My husband will be attending into 2012. I know that having this money will affect our FAFSA reporting and tax base. We are thinking of paying off the house and existing debt but have been told that carrying the mortgage is an advantage in terms of taxes. We have very, very low personal income at this time (>$10,000). Any advice that could be offered would be MUCH appreciated. Thank you for your time and attention to this matter. Elizabeth, River Falls, WI

Answer: I’m sorry for your loss.

First of all, I want to suggest that the common refrain “carrying a mortgage is an advantage in terms of taxes” is (mostly) wrong. Yes, the mortgage interest deduction is a nice benefit for many homeowners. It reduces the cost of debt. It’s also one of the most over-hyped breaks in the tax code (and there’s a lot of competition considering how Byzantine is the U.S. income tax).

The mortgage interest break is a deduction. It only reduces your taxable income (as opposed to a tax credit which actually reduces the amount of tax that must be paid.). The higher your tax bracket the more valuable the deduction, and vice versa. Right now, you’re in a tax bracket where you really can’t benefit from the break anyway. The value of the mortgage interest deduction also declines in the later years of the mortgage when the interest portion of the monthly payment is much smaller than in the early years.

You’re probably better off taking advantage of the standard deduction–and that’s the case for many homeowners.

Even more important, the value of the deduction is swamped by the interest savings from paying off the mortgage early. So, from this tax code standard there really isn’t a penalty for eliminating debt.

However, there are other reasons for not paying off the mortgage in full (as opposed to paying it off on a faster schedule than the contract calls for). Among the most important factors is the opportunity to create a well-diversified investment portfolio. You shouldn’t have all your investment eggs in one basket, such as a home. Another factor to consider is using at least some of the money to make sure you have an adequate financial safety net. Savings not only protects you from downside risk, but it gives you the means for greater freedom of choice, especially when graduate school is over.

By the way, I would resist any pressure or sense that you need to act quickly. It might take you a year or 3 years to decide what to do with the inheritance. That’s okay. If you put the money into safe savings it will be there when you figure it out. And maybe you’ll decide the right thing to do is pay off the mortgage.

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