The temptation of paying off your mortgage
Winning the lottery and suddenly having a large sum of money can be incredibly exciting. One of the first thoughts that goes through many winners’ minds is the idea of paying off debts, especially costly ones like mortgages. The chance to be completely debt-free and own your home outright is certainly tempting. Here are some reasons why you might want to pay off your mortgage if you win the lottery:
- You’ll own your home free and clear. No more monthly mortgage payments!
- It provides a sense of financial security to own your home outright.
- You’ll be able to invest more for retirement or other goals since you won’t have a mortgage payment.
- There’s peace of mind in not having a large long-term debt.
- You’ll be able to qualify for better interest rates if you need to borrow money in the future.
- Potentially less financial stress or burden on your family if something happens to your income.
For many lottery winners, the emotional benefits of paying off their mortgage seem to outweigh the numbers. After years of dutifully paying interest and principal every month, the chance to finally be rid of a mortgage can be too good to pass up.
Reasons to think twice before paying off your mortgage
However, before taking a large chunk of money to pay off your mortgage, it helps to pause and consider these factors:
- You may lose tax deductions for mortgage interest and property taxes.
- Your money may earn a higher return if invested elsewhere.
- Paying off a low, fixed-rate mortgage may not be the best use of funds.
- You lose the forced savings aspect of a mortgage payment.
- Your mortgage provides useful leverage for investing.
- You lose flexibility in case you need access to equity in your home.
The potential tax benefits of keeping a mortgage are often underestimated. By paying off your home loan with lottery winnings, you’ll lose the ability to claim deductions for mortgage interest and property taxes on your taxes. For those in higher tax brackets, these deductions can provide substantial savings each year.
You also need to consider that by tying up a large portion of your windfall in your home, you are missing out on the potential earnings from investing that money elsewhere. Even conservative investment vehicles like bonds or certificates of deposit may earn a higher rate of return than what you’re paying in mortgage interest. Investing those funds gives you the flexibility of liquidity that paying down your mortgage does not.
If your current mortgage has a low, fixed interest rate, you need to run the numbers to see if paying it off early makes sense. With rates under 5%, you may come out ahead by keeping the mortgage and investing your money elsewhere. Refinancing your mortgage after winning the lottery could also potentially allow you to withdraw some equity while keeping favorable rates and terms.
For some, there is also a psychological benefit to maintaining a mortgage payment as a form of forced savings. If money is no object, it can be tempting to overspend. Keeping your mortgage payment provides an incentive to budget.
Your mortgage also gives you useful leverage for investing. For example, you can take some of your winnings and use it as a down payment to buy rental property. Being able to deduct mortgage interest expenses on those rental properties helps reduce your taxable income. Had you paid off your own home, you would not have as much leverage available.
Finally, a big lump sum prepayment on your mortgage gives up flexibility to tap into your home equity if needed. After paying off your loan, it becomes much harder to access funds if an unforeseen large expense comes up down the road. Having available equity can provide an attractive source of cash when needed.
Crunching the numbers
To make the best decision on what to do with lottery winnings, it’s critical to run all the numbers on your specific situation:
- Interest rate and years remaining on your mortgage – Determine savings from eliminating interest payments.
- Your tax rate – Calculate the lost tax deductions if you pay off your mortgage.
- Investment options – Research rates of return to estimate earnings if you invest the lump sum instead.
- Big upcoming expenses – Factor in any major costs like college tuition or retirement.
- Your overall financial plan – Decide if paying off the mortgage aligns with your goals.
This exercise will provide the financial context to judge if foregoing your mortgage makes sense or if you’d be better served investing the funds. Crunching the numbers also helps overcome the initial emotional temptation to pay off your home.
Here is a table to help compare your potential savings from paying off your mortgage versus estimated investment returns. Update with your own mortgage and investment figures:
| Option | Savings / Earnings |
|---|---|
| Pay Off Mortgage | $35,000 (eliminated interest) |
| Invest Lump Sum | $42,000 (at 6% return) |
This basic analysis shows investing the lump sum could potentially earn $7,000 more compared to paying off a mortgage in this example. Running these projections with your specific numbers will provide the data to make an informed decision.
Other options beyond all or nothing
Rather than deciding to pay off your entire mortgage or invest all the funds, there are intermediate options to consider:
- Make a lump sum payment to pay down the principal – Reduces interest paid over time without wiping out the entire balance.
- Pay additional toward principal each month – Helps pay mortgage down faster.
- Refinance your mortgage – Could withdraw some equity while maintaining a low rate.
- Pay off second mortgages or high interest debt – May provide better return than paying down low rate first mortgage.
A hybrid approach means you can achieve a portion of the emotional benefit of paying down your mortgage while still leaving funds available for investing. This balanced solution may give you the best of both worlds.
How lottery winnings are taxed
Before making any big financial decisions, it’s important to understand the tax implications of your lottery winnings:
- Federal taxes – You will owe federal taxes at your ordinary income tax rate, up to 37%.
- State taxes – Most states withhold state income tax upfront, from 4-8%.
- Future income – Interest and gains on investments from winnings are taxable.
- Tax filing status – Married couples have different considerations than singles.
- Withholdings – You can opt to have taxes withheld when you claim winnings.
- Estimated payments – You may have to pay estimated taxes quarterly on investment income.
Immediately setting aside up to half of your lottery winnings for taxes can prevent costly surprises or penalties later. A financial advisor can help you make a tax plan when claiming lottery winnings.
Protect your lottery winnings
Coming into sudden money can also expose you to increased risk. There are several smart ways to protect your winnings:
- Avoid publicity – Publicity puts you at risk for scams or unwanted requests for money.
- Don’t rush big decisions – Take time to consult professional advisors before making any major moves.
- Don’t overspend – It’s easy to get carried away. Stick to a reasonable budget.
- Invest conservatively – Focus on asset protection rather than big risks.
- Create trusts – Trusts can shield your assets from lawsuits, creditors, and ex-spouses.
- Make an estate plan – Ensure your assets pass to your chosen heirs and charities.
- Buy insurance – Protect yourself with good liability and disability coverage.
Resist the temptation to indulge too excessively in luxuries or shower family and friends with lavish gifts. The money can disappear quicker than you imagined. Follow solid financial planning practices to preserve your nest egg.
Think through priorities before deciding
Windfalls like winning the lottery present a unique financial opportunity if managed wisely. Before choosing whether to pay off your mortgage, make sure you align the decision with your overall financial priorities:
- Save for retirement – Lottery winnings can fund your retirement savings in a tax-advantaged way.
- Pay for college – If you have kids nearing college age, consider contributing to their education.
- Start a business – Fulfill your entrepreneurial dreams with some startup funding.
- Give to charity – Donations can make a big impact to causes you care about.
- Save for goals – Bank the funds until major expenses like a home renovation come up.
- Invest – Let the money grow over the long-term in the market.
Once you identify your top priorities, you can determine if eliminating your mortgage should be your first move or if another goal deserves those funds. Aligning all your financial decisions with your goals will lead to the best outcome.
Who should pay off their mortgage with lottery winnings?
While there are many factors to consider, here are some scenarios where paying off a mortgage with lottery winnings could make sense:
- Low-income seniors – Eliminating mortgage expenses can stretch limited retirement income.
- Savers close to retirement – Maxing out retirement accounts to catch up may be a priority over investing a lump sum.
- Low mortgage rate – Under 3%, returns from paying off mortgage may beat investment options.
- Big state tax benefits – Large state tax deductions for mortgage interest and property taxes weigh on decision.
- Job uncertainty – Reduce expenses in case of unexpected job loss.
- Peace of mind – For some, debt-free homeownership outweighs any other factors.
On the other hand, these situations suggest investing your winnings may make more sense than paying down a mortgage:
- Long time until retirement – Time to invest and earn returns.
- Mortgage rates high – Paying off a mortgage over 5% seems attractive.
- Big upcoming costs – Kids’ college tuition or weddings may take priority.
- Want to move – Plans to relocate soon point to investing the funds.
- Low tax bracket – Reduced mortgage interest deduction doesn’t provide much tax benefit.
Assessing your personal circumstances helps determine if your mortgage should be the first priority for lottery winnings. For many winners, contributing toward other financial goals while keeping up mortgage payments leads to better outcomes.
Consult a financial advisor
Before committing your lottery winnings, it can provide great value to sit down with a financial advisor. An expert guiding you through this big financial change can help avoid costly mistakes and align your decisions with your life priorities.
Questions a financial advisor can help answer:
- Should I pay off debts like my mortgage, student loans or credit cards first?
- What investments should I move current savings into after paying off debts?
- How can I withdraw money from retirement accounts if needed before age 59 1/2?
- How much should go towards college savings for kids compared to retirement?
- What expensive items can I ‘afford’ to splurge on responsibly?
- What professionals can help protect my assets like estate planners and tax experts?
- How do I respond to requests from friends and family for financial help?
With complex tax rules around lottery winnings and many competing priorities, getting unbiased guidance leads to better outcome. A fiduciary financial advisor has a legal duty to protect your best interests.
Conclusion
Coming into a sudden windfall like winning the lottery sets up a fantastic opportunity to secure your financial future. While paying off your mortgage may be an emotionally tempting first move, make sure you consider the numbers and alternative options. Aligning your decision first with your financial priorities rather than reacting can lead to the optimal outcome. Investing your lottery winnings may ultimately allow you to earn higher returns while maintaining the favorable debt profile of your mortgage. But every situation differs – working through the pros and cons and consulting professionals will let you make the most of your winnings.
