Paying Off Mortgage With Inheritance

Lisa writes in with the following question regarding mortgages and inheritance:

My father-in-law passed away recently, and we would like to pay off our 2nd mortgage with some of the inheritance money that we will be receiving. We have been in our home for 15 years and took out the 2nd mortgage in 2006. While the thought of reducing our debt and increasing our monthly savings is our first priority, my husband and I are not sure how this will affect our taxes next year. Also, we were planning to move sometime within the next 2 years after our daughter graduates from high school. How will this affect the price that we sell our home for?

Lisa, first of all, I’m sorry to hear of your father-in-law’s recent passing. I know this is a difficult time for both you and your husband. And what a blessing it was to receive an inheritance.

As you know, I’m not a big fan of mortgages (they are a necessary evil for most of us), and I like second mortgages even less! That said, it may or may not be the best time for your to clear that mortgage depending on the shape of the remainder of your family’s finances.

First, if you do not have an adequate emergency fund, I would park some of this money in an online savings account to cover several months of household expenses. If you have already established a solid emergency fund, I would use some of the remaining money to clear high-interest, non-deductible debt such as credit cards and high-interest loans.

With your emergency fund in place, and debt free except the house (and the second mortgage), it is time to evaluate the second mortgage. I like Dave Ramsey‘s rule here: if the second mortgage exceeds half your annual income, I would simply include it as “house debt” and pay it down on schedule (or a little early as income allows). If the amount of your second is less than half your annual income, use inheritance funds to clear as much as possible.

If you were deducting interest on the second mortgage at tax time this will affect taxes. However, I’ve never understood the argument to send a mortgage company $10,000 a year in payments to save $3,000 a year on taxes (rough example). My personal rant aside, if you have questions about the tax implications it might make sense to talk with a tax professional to determine what the bottom line impact of paying off the second mortgage would be.

As for selling the home in a couple years, by paying off the second mortgage you’ll increase the likelihood that you will get some equity out of the sale. Paying off mortgage debt also gives you more wiggle room when setting the sale price of your home. If the house was fully leveraged, you would be less likely to be in a position to reduce the price for a quick sale.

Whatever you decide, my best advice is to move slowly. When we lose family members emotions are raw, and rarely do we make sound financial decisions when emotions are driving us to make them. There’s nothing wrong with parking the money in a money market account, or CD, for a few months while you think over how best to use the inheritance. You only get one opportunity to use this inheritance wisely, so make it the blessing it was intended to be.

Ask the Readers:  What advice do you have for Lisa and her husband?

Comments

  1. I loved the line in this blog about not understanding paying $10K in interest to save $3K in taxes. When I told someone I wanted to refinance to a 15 year mortgage she actually acted like it was the dumbest thing she had ever heard! “But you want that tax deduction!”

  2. As their plans are up in the air, I’m for parking the money also til they figure out what they are going to do. And yes, first fund that emergency plan.

    Then think about realistically how much they can get out of their home when they sell(over what they owe)…will that money help out more now (as in easing cash flow for now by dropping the 2nd) or will it be needed for a large down on the next house. If they are going to get very little out of the house over what they owe, they might want to just keep the $$ now for a large down on the new place. Hard to tell without seeing the figures.

    Definitely park it somewhere secure and safe, like CD’s tho – so it’s locked up and not tempting them :)

    Another thought tho is to fully fund their IRA’s for the year also. A year lost on an IRA is a year lost forever plus interest.

  3. Agreeing with you & Bethany, I think the thrill to get the tax deduction (instead of paying down on the mortgage, and not paying that much interest in the first place) comes from the same people that get excited at a tax refund cheque. The fact that the tax man is some how giving them money back or “cutting them a break” blinds them to the reality that they’re missing opportunities to put the money to better use.

    -gumnos

  4. Great Advice. I concur; with the current status of the housing market & a planned move, paying off the house would tie up all of their funds. Also, there will be expenses associated with their daughters education. Money in the bank is the way to go on this one.

  5. The good thing about parking the money is that it’s an easily reversible decision.

    A decision to pay down a mortgage is not so easily reversible, because a mortgage isn’t set up so that a borrower can just call up the bank and say: “Oops, I need an extra three hundred until Friday, can you tack it on to the mortgage?” So it pays to think everything through and to make sure the savings and retirement funds are flush.

  6. The price you sell your house for should have NOTHING to do with how much you owe on the first or second mortgage.

    Yes, it’s nice to turn a profit.

    But unless your house is priced right for the local market, it will not sell.

    If I buy a house, I don’t care that the previous owners owe $40k on their second mortgage and have priced their house to cover that.

    I just care about getting a good house at the appropriate price.

  7. This is a classic question that seems to come up about weekly, and there are varied answers and plans–pay off the mortgage, build up an emergency fund, stash it into an IRA, stash it into a CD.

    It’s preposterous to assume that any of us can give reasonable advice knowing nothing about the financial and life circumstances of the questioner. How old is she? How much do they currently have in an “emergency” fund, in retirement savings? How much other debt are they carrying? How stable are their jobs? How much longer do they plan on working? Are they planning on funding their childrens’ educations?

    What’s worrisome about this topic is the original questioner asks two questions that are not only irrelevant, but hint at the fact that she has a very poor grasp of her finances in general.

    Most people way over-estimate the tax benefits they are reaping by deducting mortgage interest. They confuse “deduction” with “credit,” and even if they understand this difference, they don’t consider the opportunity cost of giving up the standard deduction in order to itemize.

    The second question, and this one’s even worse, is “How will this affect the [sale price]?” Kacie addressed this above already. It won’t. It makes no difference how much of the house you own at the point of sale vs. how much of it you are renting from the bank. When you were shopping for a house, did you ask how much the sellers owed on their mortgage in order to determine a fair price? Of course not.

  8. I will go against the flow. Unless you are in a totally upside down state (CA,NV,FL) or you are upside down, save an emergency fund and then pay off your mortgage. The money that is freed up would be wonderful.

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