Did you just receive an inheritance or bonus? Or do you have one on the way? In this episode of Coffee with Brendan, he encourages you to think twice before deciding what to do with that cash.
Most investors are inclined to pay off their mortgages or pop those funds into savings, but with today’s inflation coupled with low interest rates, that might not be the right move for you. Watch now to learn how Brendan suggests you make that money work for you. Bonus: he actually has coffee today!
Inheritances and bonuses – what should you do with them?
Should you pay off low-interest loans? What happens if you don’t
Calculate how much liquidity you need
A breakdown of hypothetical situations – paying off debt v. investing
How to make that money work in your favor
And welcome to another episode of Coffee with Brendan, and actually today, I actually do have my coffee. I'm going to take a little sip right now, and we'll talk a little bit about another question that I got this past week, this time about either getting an inheritance or bonus from work and what to do with that money.
So often, people just simply default to one of two things. They either say hey, I got $100,000 because my aunt passed away or I got $100,000 because my company did really well, and I cashed out some stock. So what do I do with that money? What they typically do is they either put it in the savings account or they pay off their mortgage. I think part of that comes back to, I always say this, that my psychology degree comes in sometimes just as often as the financial planning degree, because a lot of it's very Freudian, it comes back to what happens in childhood and what you've been taught over the years. Everyone is always taught to pay off debt and to pay off your house first and foremost, the old mortgage-burning parties that people used to have back in the day, but that's not always the case anymore because of where interest rates are.
Interest rates are so low right now that paying off your mortgage isn't the best thing. Let me give you an example, and we'll see if we can figure this out. Let's say, let me get my pointer here, let's say that you either inherit or you get $100,000 from a bonus through work. This is currently your debt situation. You have a mortgage at 3%, $50,000. You got a credit card at $10,000. You got a credit card balance of $10,000, which has got about a 15% average annual interest rate. Student loans, $30,000, and an auto loan of $10,000.
I would tell you that the vast majority of my clients would say, I want to take that $100,000 and just pay off everything. I would say that, from a behavioral feel-good standpoint, that is the majority of the people that are probably watching this video right now... Is you have $100,000, let's just pay off all this debt and be done with it. Now, I think what you're doing in that case is you're letting the banks off the hook, frankly, because right now, inflation's at about 4%. In other words, your money has to keep growing at 4% in order to keep up with the cost of living going up. What that pretty much means is if you are paying off a 3% mortgage and you're paying off a 1% loan with $60,000 of that, you're doing the bank a favor.
The bank is loaning this money out and only getting 3% and 1% from you, but meanwhile, the cost of everything is going up by 4%. The bank is losing money in that transaction. So my recommendation would be not to pay off the mortgage and not to pay off the auto loan, keep those intact, and even further, if you're itemizing your expenses, that 3% is not really 3%, it's less than that because the interest that you pay on your mortgage is tax deductible, again, if you itemize your deductions on your tax return. You definitely want to get rid of these two, because again, those are guaranteed losses, 15% and 6%. As we all know, never carry a credit card balance, so do whatever you need to do to pay that off. That's $40,000 of the money, so what do we do with the rest of the money, if we're going to keep the mortgage and we're going to keep the auto loan?
If you put it in checking, you're probably going to get next to nothing or maybe a fraction of a percent. If you put it in savings, you might get a little bit more. Investments should make six plus percent. Now, with that said, that is variable, that is not guaranteed, so I can understand if people would say, I don't really want to put it into the market at this point. With that other $60,000, you definitely want to have a good cash reserve. Typically, the rule of thumb is anywhere between three and six months of your fixed expenses is what you should have in cash. If your cash reserves are $3-5,000, then yeah, throw some more of that money into these low-yielding investments, because you do need to have some liquidity... But a good chunk of it should go into something that's making 6% as opposed to money that's losing 1% and 3%, especially if inflation is at 4% right now.
How do you do this? Of course, you could just call up someone like me and dump it into one of your non-IRA buckets, but instead, what I would probably do is make sure you're maxing out your 401ks and retirement plans at work. Also, if you haven't, if you're eligible for a Roth IRA, put it into the Roth IRA. You can only contribute about $6,000, $7,000 if you're over 50, but that would be another good place for it.
Bottom line is that's pretty much what I would say, is don't just simply default to paying off the loans. That's not the right thing to do from a dollars and cents standpoint, especially with inflation as high as it is and interest rates as low as they are right now. Think about investing some of that, building up your cash reserves, and things like that. That's pretty much my message for today. I hope you have a great weekend, and we'll chat again next week. Thanks.
The LPL Financial Registered Representatives associated with this site may only discuss and/or transact securities business with residents of the following states: CA, CO, CT, DE, FL, GA, IN, MA, ME, MT, NC, NH, NJ, NY, PA, RI, SD, TX, VA & VT
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.