Reader, Becky, wants to know the best way to utilize an inheritance Should she pay off her debts or mortgage? Financial coach Guirlene walks her through how to decide which option is best for making the most of her money.
Receiving an inheritance can provide an opportunity to improve your financial health. However, it also presents a challenge: how to use this money wisely. One of the most common dilemmas people face is whether to pay down their mortgage or clear other debts. This decision can significantly impact the course of your financial future. Given that many people don’t stumble into this much money frequently, it’s critical to approach it with much care and consideration.
Debt vs. mortgage: Factors to consider
Inventory of debts
Before making any decisions, it’s crucial to have a clear understanding of your current financial situation. To do this, begin by listing all your debts. This includes:
- Credit cards
- Personal loans
- Student loans
- Payday loans
- Mortgage (both investment and residence properties)
It’s important to include all outstanding debts, no matter how small, insignificant, or how far away the payment deadline may seem. This will give you a comprehensive and realistic view of your financial obligations. It will also help you prioritize them better when trying to pay off your debts.
While compiling your list, it’s helpful to make note of which debts are “good” and which are “bad”. The difference is that good debts tend to have low interest rates and involve an asset that increases in value. Bad debts, on the other hand, have high interest rates and correlate with assets that decrease in value.
Evaluating your debts
Once you have a complete list of all your debts, evaluate their respective interest rates and repayment terms. For starters, look at the annual percentage rate (APR) for each debt, which accounts for both the interest rate and other additional fees. This is a particularly larger problem for credit card debt. Their tendency towards high-interest rates and high credit utilization can negatively impact your credit score. Ultimately affecting your ability to borrow money in the future.
Make sure to consider the repayment terms, such as:
- Length of the loan
- Timing of payments (monthly, weekly, or yearly)
- Any associated penalties for early repayment
- Minimum payment amounts
Also, it’s worth noting whether any of the debts allow lump sum payments. Which can help pay off debt faster by decreasing the overall balance of the principal.
All these pieces of information are essential components of debt management. Knowing them will help you separate costly from less costly debts and give you a better understanding of where your funds will have the greatest impact.
Decision: Debt repayment
Tackling high-interest debts
If you have a lot of high-interest debts, making a lump sum payment from your inheritance could be more beneficial than using a debt strategy like debt consolidation. High-interest debt can be on things such as credit cards, payday loans, personal loans, and car loans. These types of debts can quickly accumulate and cost you more in the long run. Therefore, it’s usually a good idea to prioritize paying off these debts first. By doing so, you can save a significant amount of money that would otherwise go towards interest payments. Additionally, once these debts are paid off, you can redirect the funds to other financial goals. This act of paying off higher-interest debt first is also known as the avalanche method.
Tackling low-balance debt
On the other hand, instead of the avalanche method, you can try paying off debt that has the lowest balance first. Then pay off the debt with the next lowest balance. This strategy is known as the snowball method. This method may mean the total balance in your debt portfolio will decrease slower than other methods. The advantage is that the act of completely eliminating debts more frequently, which this method promotes, can sustain your motivation to pay off your debt.
Decision: Paying down your mortgage
Compare low-interest debt and mortgage interest
If your mortgage interest rate ends up higher than your other debt, it might make more financial sense to focus on paying down the mortgage. The main benefit of paying off your mortgage faster is the resulting increase in home equity. Effectively providing more protection against times of instability in the housing market. It is also important to note that mortgage interest is tax-deductible if you have a property that is giving you some form of rental income. Which can be advantageous in helping you save money. However, tax laws can be complicated and confusing, so it’s advisable to consult with a tax professional.
Alternatives: Other things you can do
Building an emergency savings fund
Instead of debt repayment or paying down your mortgage, consider using your inheritance as an emergency savings. Financial experts recommend having at least three to six months’ worth of living expenses. It’s best that these savings are placed in a liquid (easily accessible) account. such as a high-interest savings account. These savings can protect you during financially challenging times like a job loss or medical emergency. Emergency savings can go a long way to prevent you from going further into debt in the future.
Employer retirement contributions
You could also consider contributing to an RRSP. This is particularly beneficial if your employer matches your retirement savings plan contributions. For instance, if your employer will match up to 5% of your income, then contribute enough to maximize up to your limit. However, it’s important to remember to stay within your contribution limit, as going beyond has tax consequences. Employer matches are essentially free money and should be fully utilized. Maximizing your employer match can significantly boost your retirement savings. However, it will also halt your debt repayments.
The bottom line
Overall, managing an inheritance can be complex. It’s often beneficial to seek professional advice from a financial advisor. Also, consider researching CMHC for the most up-to-date information on housing. These resources can help you analyze your specific financial situation and provide you with a more tailored solution. Ultimately, take your time but be thorough in your research. The decision of where your inheritance should go depends on your financial goals, risk tolerance, and overall financial plan.
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