Let’s say you have a cash windfall, whether it’s from a relative that passed away, an insurance claim, or you just got lucky with the lottery.
The big question is what to do with it. It’s a good problem to have! Unless you are planning on a trip to Las Vegas, any debt that you pay off would be beneficial.
But it is better to pay off some before others.
For instance, if you have a mortgage of 5% and you are deducting the interest in the 25% tax bracket, your mortgage cost is actually 3.75%.
Paying it off would be the same as an investment return of 3.75 percent.
If you have credit card debt, however, pay this off first. Depending on your interest rate you could wind up with a 19% to 29% return.
It would be very hard to generate this type of return in the market.
If any debt-payment “return” is above the inflation expectation for the near future, then it could be reasonable to pay off your mortgage or other debts.
Another consideration is liquidity. If you need the money in the future, equity in a home can’t be retrieved quickly.
You would have to take out a home equity loan, and that could take 30 to 45 days. Then you would have to make payments again on the loan that will most likely have a higher interest rate.
If liquidity is important you could invest the funds in an S&P index fund, where you would expect to see a return between 8% and 10% over the long run.
Plus, you will be able to get any amount from your brokerage account within a few days by selling off a portion of the fund.
The risk is that, in the short run, stocks could go down. You won’t be forced to sell at a loss, but if you need cash it won’t be easy to take a loss in order to get it.
If you do pay off your mortgage and are still working, you could choose to continue to pay your original loan payment to yourself. This can be in the form of contributions to a dividend-paying stock fund.
Alternatively, you could open a tax-advantaged Roth IRA.
Use a dividend-paying ETF to generate income and purchase more to grow the account. This will allow you to continue to grow your account for when you will really need the money.