It’s All About the Cash Flow, Baby! (Deciding How to Invest a Lump Sum)

If you read our January financial update (and as you’ll read in our February financial update), we recently received a big cash lump sum from Mr. RFL’s annual bonus and vesting of stock compensation.

This money propelled us past our financial independence goal, yay! Now we now need to decide what to do with it. So, I’ve been analyzing how to best utilize or invest this lump sum, with a focus on cash flow.

Why focus on cash flow?

Because we’re now in the “work optional” stage of our FIRE journey. Although Mr. RFL’s salary more than covers our current living expenses, having adequate cash flow will become important once he stops working.

It’s time to focus more on increasing our passive income streams as we begin to transition to early retirement.

What if you received most of your salary at the start of the year?

While we didn’t earn it all, we did receive more than half of our expected income for the year… by mid-February.

Mr. RFL makes good money (low six-figures), but the biggest upside to his job comes from the potential for variable compensation. This can come in the form of an annual bonus and/or stock compensation, both of which can be either incredibly lucrative or worth hardly anything, depending on the year.

During the pandemic bonuses were very low and our stock options had little value because the market was down. This reduction in variable compensation was enough to push us below the income threshold for receiving pandemic stimulus benefits for the first time (with a little tax planning).

Thankfully, his company weathered the turbulence well and bonuses were much higher this year. Additionally, Mr. RFL received in a large tranche of company stock and options in January, which took 3 years to vest.

How much cash was this “lump sum”?

Almost enough to pay off our entire mortgage today… if we wanted!

It was more money than we’ve ever received over such a short period of time.

And, indeed, paying off the mortgage is one of the options we considered. While the cash lump sum wasn’t quite enough to cover the full mortgage balance, we’d have enough if we also liquidated other (previously vested) stock options.

The other obvious choice would be to invest the money.

We’re not into crypto, NFTs, or anything else super trendy. If invested, we’d put the money in a total stock market and/or high-yield dividend index fund.

Finally, there’s real estate investing, which is another good option for cash-flow. However, while real estate is something we’re considering for the future, we don’t have the time or energy for it right now.

But, who says we have to pick just one option? We could allocate the money across any or all of these options to hedge our bets, which is what this indecisive girl usually leans towards.

Option 1: Get rid of the mortgage

I’ve written about our thoughts regarding whether to invest extra cash or pay down the mortgage before.

Although our analysis on this topic led us to stop paying extra towards the mortgage after refinancing to an interest rate of 2.5%, the idea that we could pay the mortgage off today is certainly exciting. Mr. RFL and I both had a similar giddy reaction upon realizing that we could do this.

However, it doesn’t take much to beat 2.5% in the market.

That said, the “math” typically used to support investing over paying down the mortgage is based on probability and historical and estimated market returns. There is no way to actually know which choice will yield the best financial returns. Math also doesn’t take into account any psychological benefit we might get from being mortgage-free.

As far as cash flow goes, paying off the entire mortgage today would immediately free up cash flow each month by eliminating our existing mortgage payments. Our previous analysis was on paying extra, rather than eliminating the debt and immediately netting the benefit of increased cash flow.

Reconsidering our decision NOT to pay off the mortgage early

Our current 5-year plan involves us selling this home in about 4 years. As such, our time horizon and potential for savings is much different than someone planning to live in their home for another 15-20 years.

There are pros and cons to having a shorter timeline. On one hand, we’ll be able to cash out of our home equity sooner than someone planning to stay in their home for a long time. The guaranteed (tax-free) return on paying off our mortgage is easily to calculate, but not significant over a shorter time period. However, the shorter time horizon also makes investing the money in the stock market a lot riskier.

In my post on selecting estimated market returns, we saw that the stock market is much more volatile and unpredictable over short time periods. It’s also more likely to experience negative returns.

Over a 10 – 20 year period, I feel pretty good about beating our 2.5% mortgage rate in the market. But, over a 3- 4 year period? I’m not so sure.

My confidence level was very low at the end of 2021. So low, in fact, that I was reconsidering our original conclusion on this topic. Ironically, the ~10% market correction at the start of 2022 actually gave me more confidence that we could beat 2.5%. Either way, we’re still likely to see significant volatility in the near term that makes this decision more difficult.

Analyzing the mortgage payoff option… one last time.

At the time of my analysis, we owed just under $180,000 on our mortgage.

If we were to cash out of Mr. RFL’s equity and use the funds to pay off our mortgage balance today, we would immediately free up monthly cash flow of $1,334 (~$16,000 per year). We could invest that extra cash flow in the stock market each month to increase the cushion in our portfolio.

By our planned sell date in May 2026, we’d have saved around $68,000 in cash outflows, including $16,500 in interest expense. We also would have added a significant chunk to our investment portfolio, though how much would depend on how we invested that money and the actual market returns (we’ll get into this further down).

Option 2: Invest the money

On the contrary, we could just immediately invest the cash lump sum in index funds.

For the simplicity of this analysis, I considered only Vanguard’s High Yield Dividend Index fund (VYM) and Vanguard’s Total Stock Market Index Fund (VTSAX).

For a long term plan, a total stock market fund is probably the best option, as overall market appreciation should beat income-generating investments over longer periods. If we were looking at a time horizon of 10 or more years, putting this money in a total market index fund would be my hands-down choice.

However, given our shorter time frame, there is a much greater risk that the market won’t beat the annual tax-free return of 2.5% paying off the mortgage provides. Because of this, a safer play might actually be a dividend fund.

It’s all about the cash flows…

Why might a dividend (or other income generating investment) be the best compromise in this scenario?

Because it gives us the opportunity to earn cash flows at or near what our mortgage rate is… regardless of market appreciation.

For example, recent yields on VYM are approximately 2.75%, which after dividend taxes is 2.34%. This is only slightly below our mortgage rate and has the potential for market appreciation.

If we chose a riskier bond investment, such as Vanguard’s High Yield Corporate Bond fund, the current yield is just over 4%, which would be a around 3% after-taxes, depending on our tax bracket.

In either of these scenarios, we can create cash flows that are close to those we’d save by paying down the mortgage. Additionally, the cash flows earned could then be reinvested and compound over time to earn more. Whereas the maximum value of the mortgage interest savings is fixed and declines as the loan balance decreases.

Dividend and interest yields are never a guarantee. However, they offer more short-term stability than relying on market appreciation alone, which makes them more attractive to me in our scenario.

Additionally, cash flows that don’t require the sale of assets can help to offset expenses in early retirement, without eroding our base investment portfolio. That’s a major plus when it comes to paying for early retirement, especially if there’s a down market during our early years.

We’ll want to build up our passive income before retiring, so why not start now?

Comparing options

Similar to my initial mortgage paydown analysis, I compared each of these options under various market return scenarios. In the mortgage payoff scenario, we’d have no debt and a small investment balance in 4 years. While in the investing scenario, we’d have a larger investment balance but also a mortgage balance.

Here’s a summary of the net results of the scenarios I considered for VYM (inclusive of dividends):

Similar to my initial analysis, and as expected given the short time period, the break-even point falls between 2% and 3% of gross annual returns (inclusive of dividends). The results were slightly more biased towards the investing option when I used VTSAX as the primary investment.

What will we do with this cash lump sum?

Although it’s tempting to just pay off the mortgage, we decided not to pursue this option after running the numbers.

Most of the likely scenarios (in our opinion), would result in investing being the superior option. Additionally, we plan to itemize our tax deductions this year, so any mortgage interest we pay will be deductible, resulting in an even lower effective interest rate.

Ultimately we decided to pay a small portion of lump sum ($9,000) towards the mortgage and will invest the rest.

As we liquidate Mr. RFL’s company stock, we’ll invest the money in both total stock market and income-generating funds (dividends, corporate bond, or high yield bond). We’ll aim for a 50/50 split, with our regular monthly investments continuing to prioritize total stock market index funds.

Of course, we’ll let you know how it all plays out.

What would you do if you received a cash lump sum?

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