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July 12, 2001
What to do with a windfall: Pay off the house
or invest it?
WEST LAFAYETTE, Ind. – A Purdue University professor asks: If you receive a $100,000 windfall, would it be better to pay off your home mortgage or to invest the money?
"Since housing is most people's largest expense, and interest paid over the years is generally much larger than the principal, most people think of paying off their mortgage entirely to reduce the interest they have to pay," says Flora L. Williams, a professor of consumer sciences and retailing and an accredited financial counselor.
"But people generally don't have the expertise or tools to compare the amount saved in mortgage interest charges with how much they can earn by saving and investing the $100,000," she says.
Comparisons among alternatives are complicated by different interest rates (paid and earned), lengths of mortgage, tax brackets and returns on savings and investments.
"But, generally, we find that clients earn more money from saving or investing a lump sum than using it to pay off a mortgage," Williams says.
Consider: the mortgage payoff for your house is $100,000 on an 8 percent, 30-year, fixed-rate loan when the windfall arrives. If you pay off the mortgage, you save $164,160.
That sounds good until you realize that the same $100,000 invested broadly in the stock market over the 30 years of your mortgage would yield almost $1.9 million. Those earnings assume an average return of 10 percent, the historical average annual return on a broadly diversified stock portfolio, and reinvesting dividends.
The best approach, though, Williams says, is to invest the $100,000. Then, double your monthly mortgage payment, pay off the mortgage loan early and continue to save or invest the amount of your mortgage payment after the early payoff.
"This method yields the greatest overall return, combining reduced mortgage interest cost and interest or investment returns earned," Williams says.
Williams cautions that the above are general findings and that different individuals must take into account different financial obligations, tax situations, investment diversification and even personality and attitudes about home ownership, security, saving and investment.
Williams suggests that it is generally better to invest an unexpected financial bounty of any size than to pay off mortgage interest early. This strategy offers financial diversification and makes liquid assets available to handle large, unexpected expenses such as catastrophic illness, divorce or the loss of a job.
She says the lesson is that when you receive a large, or even a small, windfall unexpectedly, consider the time-value of money alternatives carefully. What seems like a logical decision could end up costing hundreds, thousands or even millions of dollars over the long term.
The following table is based on a $100,000 windfall for different mortgage interest rates, investment return and the combination of double mortgage payments and earnings by continuing to invest after early mortgage payoff (all figures based on 30-year time period).
| Interest rate % (paid & earned) |
Mortgage interest paid |
Interest earned $100K |
Mortgage interest reduced by doubling payment |
Mortgage interest savings and investment earnings from doubling plus investing original payment |
| 12 | $270,308 | $3,494,964 | $232,638 | $3,821,809
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| 10 | 215,929 | 1,883,739 | 179,697 | 2,154,833
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| 8 | 164,160 | 993,572 | 130,343 | 1,215,380
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| 6 | 115,838 | 502,257 | 86,085 | 684,389
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Source: Flora L. Williams, (765) 494-8297, floraw@purdue.edu
Writer: J. Michael Lillich, (765) 494-2077, mlillich@purdue.edu
Purdue News Service: (765) 494-2096; purduenews@purdue.edu
Related Web sites:
Purdue Consumer Sciences and Retailing department home page
Purdue Financial counseling and planning home page
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