mortgage

Floating-rate funds vs. paying off mortgage

Liz WestonDear Liz,
I inherited enough money to pay off my mortgage, which has a 3.2 percent interest rate for another 12 years. I am 67 and retired. I have been advised to buy floating-rate funds rather than pay off the mortgage. What do you think?
-- Gary

Dear Gary,
Paying off your mortgage can be a bet that interest rates won't rise very much or very fast. Floating-rate funds are a bet that they will.

Floating-rate funds invest in bonds and other debt with variable interest rates. These funds are designed to do well when interest rates rise, unlike traditional bond funds that lose value when rates go up. But these funds are far from risk-free. To get higher yields, the funds often invest in loans to corporations with mediocre or poor investment ratings. The funds limit interest rate risk, but they may offer substantial credit risk.

Of course, there's no way to know when interest rates will rise or by how much. People who believe inflation and higher interest rates are around the corner may be more likely to hang onto a low-rate mortgage. They're betting that they can get superior returns elsewhere and that inflation will shrink the relative size of their payments.

The decision to pay off a mortgage involves other factors beyond where you think interest rates will go. Taxes play a part as well. A mortgage may offer a substantial tax break, especially in the early years when most of your payment goes toward interest (which is tax deductible) rather than principle (which is not). Over time, the size of the tax break diminishes as that ratio reverses.

What to do with inheritance money | Man standing in fork: © Lightspring/shutterstock.com; Street sign: © Vitezslav Valka/shutterstock.com

Then there's diversification. Financial planners typically advise against paying off a mortgage if such a move would eat up too much of your cash reserves. You can offset that risk at least somewhat by getting a line of credit -- either the traditional kind or via a reverse mortgage -- which would allow you to tap your equity in an emergency. And some people are okay with having less cash on hand, knowing that they have a paid-for house and lower expenses as a result.

Clearly, there's a lot to consider. If the right course for you isn't obvious at this point, then this would be a great issue to talk over with a fee-only financial planner.

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