Sometimes life’s timing is perfect. We have written before about the best way to use an inheritance. Last Sunday, we came across an almost ideal scenario for when to receive an inheritance. The following question appeared in the ‘Ask the Expert’ section of the Fairfax/Nine press:
My husband and I are in our mid-30s, with a baby due in the coming months. We own a modest home that we purchased two years ago. We have a $400,000 mortgage and no other debts. This year, we are set to inherit $500,000. We both work in highly casualised, precarious industries. I’m not eligible for maternity leave. We aren’t certain how to best use the inheritance. Our fixed low-rate mortgage has 12 months left. Should we pay off the mortgage and invest the rest? Our home is old, and needs renovations and repairs.
The columnist did a reasonable job of offering advice, although was probably limited by his word count to really take this issue on. So, we thought we would be more expansive, in the hope that we can offer some food for thought for our own clients.
Firstly, how perfect is this timing? An inheritance with the potential to either (i) leave this couple debt-free or (ii) massively change their net asset position – arriving in the same year as their first child. Their benefactor should be very proud of the change they will make in this couple’s life. It’s a good news story.
As it happens, this couple is now spoilt for choice. There are many, many ways that this inheritance can make their life better, and we set out some of these below. As we do not know all of this couple’s details, we will make some assumptions where noted. Remember, some of these options can happen in combination while others are mutually exclusive. But here are just some ways that this couple could respond:
- Whatever else they do, use some of the cash to make sure that (i) their car is safe for their new child and (ii) that they do not have to work ‘stupid’ hours in the early period of their baby’s life. Their life is about to change immeasurably. This inheritance could not be better timed.
- Pay off the entire mortgage, either now or when the fixed rate period ends (with the money invested in some form of interest paying account until then). Rounding off, this would leave them with $100,000. See below for some ways that this ‘leftover cash’ could be used.
- Renovate the current house to make it as comfortable as possible. Then, with whatever cash is left, pay down the mortgage. This may still leave the couple with some debt, but their house should be worth more. Even better, it will be nicer to live in for the entire family and, potentially, less likely to be a house they will grow out of as their family grows.
- Sell the current house and buy another house worth up to $500,000 more, keeping their debt at or below the current level of $400,000. This may not reduce their debt, but it will increase their asset base. In the medium to long term, this will give them access to greater capital growth on their home. For example, if a house worth $500,000 rises in value by 10%, it is worth $550,000. If a house worth $1 million also rises in value by 10%, it will be worth $1,100,000. (This option would depend, of course, on how comfortable the couple is with the current level of debt).
- Buy another house to live in, using the $500,000 and maybe a new smaller loan if their lender will allow that. Keep the current mortgage where it is, and rent out the current home. As we do not know the value of the current home, we cannot be sure whether the rent will cover the interest expense. But if we assume a 6% interest rate (after the fixed-rate period ends), and a 3% rental yield, then the investment property will be basically cash flow positive if the house is worth more than $800,000. If it is worth less than that, and they make a short-term loss, that loss will be tax deductible (negative gearing). This suggestion achieves the same asset-expansion as the previous suggestion, but it makes the interest burden easier to bear as there is another line of income in the form of rent.
- Pay down the debt, and then take out a new (potentially smaller) loan which they use to make regular investments into a diversified investment vehicle such as a managed fund. The interest on this new loan, which will have been taken out specifically to make an investment, will be tax deductible. This is why this strategy is preferable to simply using the inheritance to directly finance the investment. They end up with the same level of asset and debt, but the debt is effectively cheaper because the interest is tax deductible.
- Pay down the current debt, and then borrow to buy another property as an investment. Same thing again: the debt is cheaper because it was used to buy an investment. The net assets are improved.
- Similarly, they could use the inheritance to pay down the debt, and then borrow back some money to buy or start a business. This could be considered a higher-risk strategy than investing in property or shares, but it is worth remembering that they both work in casualised, precarious work. Their own business might actually be a lower-risk way to earn income than their current employment, especially in the medium to longer term.
- Alternatively, but along the same lines, many of the above options that allow them to retain some cash (for example, paying off their debt and leaving them with $100,000). In such cases, the couple could consider using that cash to replace lost income while one or both of them retrain in a kind of work that is less precarious and, ideally, better paid.
- As another alternative, or even as well as the previous suggestion, in any of the above options that allow them to retain some cash, use that cash to make a personal super contribution up to their annual limit. This can be used to immediately reduce the tax liability on their annual income, which gives them an immediate cash boost. The super contributions can then use time and compounding to help them prepare for the second half of the rest of their lives. Remember, they are currently in their mid-30’s. If they live to their mid-80’s, then their super is only ‘locked up’ for half of their remaining life. What’s more, their newborn baby will turn 25 at about the time that Mum and Dad turn 60. This makes the super fund a great way to save to assist their child as an adult.
As you can see from this brief list, this couple has many options available, all of which will make their lives easier and more enjoyable. The option/s they choose will depend on their personal preferences and their longer-term goals – which may actually need refining given their changed wealth and family position. Goals might also change after the baby is born; after all, becoming a parent is probably the biggest personal change in most people’s loves.
All of this makes now a GREAT time to talk to us to think carefully before they do anything! It is always better to take your time and make one good, long-term decision, than to rush into an error and have to fix your mistake a year or two down the track.