How to Invest a Windfall

Not to humble-brag but I have an expected windfall of about $50K coming my way which is currently not earmarked. My initial gut reaction was to pay down rental property debt with it.I’ll get into all reasons later but in recent months I’ve been reading some early retirement blogs and freeing up some cash flow associated with debt payments would be consistent with that goal.

But then I started thinking about if debt reduction really provided the best return on my investment and wanted to formally explore some other options in greater detail. If after I wrote out all the pros and cons of my choices, debt reduction was still the best option then it really must be.

These are the options I’ve considered so far:

Pay Down Debt on Rental Property

The only debt our household has is related to real estate, either on our primary residence or on the 3.5 rental properties (one of our rental properties is owned with a partner). We don’t have any student loans, credit cards, or car loans so the low hanging fruit is already taken care of.

The highest of any of the mortgages is 4.85% on the most recent property we purchased. It doesn’t seem like that high of a rate, especially since interest on a rental property is deductible against rental income. The issue is that the interest is not tax deductible for me since all of my properties show loses and passive activity losses can not be offset against ordinary income (our household modified adjusted gross income (MAGI) is above $150,000 phaseout for the exemption). Since the losses can not be offset against any positive income, the interest is not tax deductible and is therefore a 4.85% after tax interest rate.

Assuming a 30% marginal tax rate, the before tax rate that needs to be compared to all other investments then becomes roughly 6.3%.

Paying down debt is guaranteed however, creating quite a pro for the move. Every penny put towards it will achieve the forecasted 6.3% before tax return. As volatile as the markets have become over the past few years a guaranteed return is comforting.

It also places the funds out of reach.This could be good or bad depending on how you look at it. It’s good that it eliminates any desire to spend it but but it’s also bad since it reduces liquidity. A home equity line of credit could be secured on the house to ensure availability of this equity but there are fees associated and lots of paperwork associated with getting it set up and using it.

Purchase Another Rental Property

At one point in my life I had a goal of purchasing one rental property per year. Then some major real estate setbacks occurred, mainly losing about $25K on a failed property in a poor neighborhood in Philly. After that experience, I lost my appetite for investing in real estate and pulled back. It took me about four years to jump back in. Prices were not fully recovered from the 2009 crash but continuing to buy throughout the entire crash would have given me some great returns.  

Then in 2012 I found myself with some excess cash on hand looking for a home. I jumped back in and invested in a rental property and then less than six months later, purchased another in 2013. Both of these properties were purchased based on location and school districts and have been very successful so once again the idea of purchasing one property per year has been rattling around in my head.

The lump sum amount would be more than enough for the downpayment on another property, pay closing costs, plus any miscellaneous repairs that would be needed. $40K was the average investment of the last two properties purchased. Unfortunately, property values have continued to escalate since that time and to match the return realized on those properties, I would have to reach further into either more dangerous areas or areas further outside of my metro area that are “up and coming”.

This option is also less attractive due to my aforementioned passive loss situation. An additional property would create more passive losses without any offsetting income. Not very tax efficient.

Peer Lending

Peer lending has been getting a lot of press in the blogosphere but I have doubts about it. Having a wife who works for an advertising company, I’m well aware of the influence companies have over the message put out by bloggers. Not that I’m doubting the ER blogger intentions, but the attention they have focused on peer lending seems unwarranted compared to other investment options.

Peer lending is sure to have returns greater than saving accounts, standard CDs or bonds but that has to be obvious right? There is additional risk and work associated with this option, so it has to provide higher returns to attract investors. In this same category, are new peer investment options like PeerStreet which is basically peer lending with real estate securitization build in. Several of these blogger are posing their realized real-world results as a way of proving out the investment but these experiments have all started over the past few years in a recovering market. I’m nervous about what happens if the market turns. It could be devastating to these investment options.

With an estimated return (based on the sites own estimates) around 7%, it doesn’t seem worth the additional risks given better options are available.

Invest in Stocks

Compared to the other options, investing in the stock market seems the most pedestrian. Its boring, obvious, and a million other people are writing about it.

Still, this options provides more flexibility and liquidity compared to the other options and after reviewing the average return data, the highest average return. Here is the historical average for the S&P 500-Stock Index averaged by decade (all numbers assume dividends are reinvested):

  • 1980s:+14.1%
  • 1990s: +14.9%
  • 2010s: -0.9%
  • 2010-2016: +12.6% 

Now I am of the belief a correction is imminent but will it be worse that the 1987 correction? The 1980s still finished up 14% even with the crash happening towards the end of the period. It seems that the commonly sited average of 10% is more than accurate.

The downside of investing in stocks is that the money is sitting in a pretty liquid account, increasing the temptation that as the balance grows to make rash and foolish decisions with the funds. Five years ago this would have been a real consideration for me but over the past year I’ve really come to appreciate controlling costs with a goal of retiring early. I think I’ve outgrown (most) of my desire for never ending toys.

Conclusion

After reviewing the expected returns along with the pros and cons, I’ve ended up back at the boring choice of investing in the stock market. To end this entry, let’s just pretend I’m going to invest the full balance in low fee index funds.

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