Too much cash: pay off mortgage, invest in market, or all of the above?

Question

My wife and I have the (pleasant) problem of having too much cash. Part of the reason is that we have been looking to upgrade to a nicer house for the last few years, but we never found the right place, and now with a kid on the way we will most likely stay where we are for the next few years. But now the problem is what to do with all the cash! My only very slight hesitation in paying off the mortgage is because the interest rate is so low, although we are not really doing anything productive with the money we have.

Our Situation: We are 40 (give or take) and we both max out our retirement contributions (with employer matching). We have a 15 year mortage at 3%, with 175K left and 300K or so of equity. We have around 875K in cash earning 2.25% or so which is being taxed at quite a high rate. We have around 375K in the markets (my wife puts some of her paycheck there every month, this is in addition to retirement)

Our Savings Rate: We saved 100K last year, although we are having our first (and only) kid this year so that will go down. My job is very secure, my wife's job is secure for the next few years, but she is interested in exploring other things and so we expect our combined income to go down somewhat in the medium term (but should always be at least 250K).

Our goal: we would like to buy a house in the 1.25M-1.5M range in the next five years but not for at least three years.

Question One: It seems reasonable just to pay off the mortage now --- have I missed anything?

Question Two: Given our goal, what is a sensible thing to do with the remainder of our cash? If you recommend rebalancing our money towards the market, how slowly or quickly should that be done?

Concerns: I'm a little worried that when the times comes to buy a house the mortgage rates will have gone up substantialy, and want to avoid having to take out a big mortgage for liquidity reasons.

Answer 1

It seems reasonable just to pay off the mortage now --- have I missed anything?

In your situation, paying off the mortgage now seems like a fine idea, it's not going to save you much in interest but it will be nice to have it taken care of. Living mortgage free may even feel so nice that you decide to alter your new house timeline.

Given our goal, what is a sensible thing to do with the remainder of our cash? If you recommend rebalancing our money towards the market, how slowly or quickly should that be done?

If the goal is to have a pile of cash for a house in 3-5 years, then market exposure is not something you want too much of, so you'd look towards the typical short-term vehicles: CD's, high quality bond funds, etc.

If your timeline is more flexible and you want a chance at higher return, then you could add market exposure to the mix with an index fund or other. The percentage mix really just depends on how much risk you are willing to take on. As far as timing goes, unless there's a cost to move money around now (like early withdrawal fee on a CD) then you should decide your mix and make it happen now, then allocate additional excess at the same ratio. If there is a penalty for moving money around now, then you'd just funnel all new excess to the appropriate investment until you reach your target mix.

You should be doing the same analysis on your retirement savings, most people shift their retirement investments to lower risk options as they get closer to retirement to reduce risk of having to work longer than they planned. Your house buying fund is pretty much the same as a 65-year old deciding if the risk of having to work a few more years is worth some potential additional return on investment.

Answer 2

With that much cash I'd just pay off the mortgage, especially if you don't itemize your taxes. Even if you do itemize, you'd still have to have that money earning at least 3% for the income tax and deductions to cancel out, and right now it's only at 2.25%.

For additional long-term savings, I'd look into the backdoor Roth IRA if you haven't already- you can get another $11K/yr into a Roth.

I wouldn't stress out too much about mortgage interest rates going up. Based on your current trajectory, even with a child in the mix I suspect you'll be able to pay cash for the new house if you want to. At that time you can decide how much you want to finance, if any, based on the future rates and your investment situation. Plus, if you sell your existing home you'll have perhaps another $500K cash to use too.

As for what to do with your cash in the meantime, based on possibly needing some or most of the amount in the next 3-5 years, I'd probably divide into 4 buckets: high interest savings, slightly higher interest CDs, high rated bonds, and market investments similar to the $375K you have now. Choose your own percentages for the buckets, but perhaps a minimum of 10% in each.

Finally, at your age I'd be fairly aggressive with your retirement accounts, compared to your current cash for the next 3-5 years.