|
  Dear
Dr. Don,
I have reviewed my budget and have an extra $200
a month this year to put toward something. I'm two years into a
30-year fixed-rate mortgage at 6 percent and two years into a five-year
car loan at 3 percent. I have no other debt. The question is should
I increase my 401(k) contributions above the 7 percent of salary
I am currently contributing (no company match), pay down my mortgage
or pay down my car? Thanks.
-- Donna Dilemma
 Dear
Donna,
It's great you have money left over at the end of the month. Putting
that money to work by either paying down debt or investing for future
life goals like retirement is a great idea. Which approach is better
depends a lot on you.
You haven't told me your age or your income so I don't
know how close you are to retirement or what 7 percent of salary
means as an annual contribution to your retirement account.
What's key here is the expected after-tax returns
on your investments vs. the effective interest rate on your debt.
If you deduct mortgage interest expense on your taxes then the effective
interest rate on your mortgage is less than the 6 percent rate used
to calculate your monthly payment. If you're in the 25 percent marginal
federal income tax bracket that means that the effective rate on
your mortgage is 4.5 percent. Being able to deduct the interest
expense on your state taxes brings the effective rate even lower.
Since you can't deduct the interest expense on your car loan the
effective rate is the 3 percent loan rate.
Choosing between making additional principal payments
on the car or the mortgage, I'd choose the mortgage because of the
higher effective rate and the longer loan term. You can use Bankrate's
Mortgage Calculator to determine the interest savings and reduction
in loan term on the mortgage or the car loan. I did in the example
below. You can use the example as a template for your own table
with your actual loan balances.
| |
Mortgage
Loan |
Car
Loan |
| Loan balance: |
$150,000
|
$15,000
|
| Remaining loan term (months): |
336
|
36
|
| Interest rate: |
6%
|
3%
|
| Loan payment: |
$922.69
|
$436.22
|
| Total payments: |
$310,023
|
$15,704
|
| Total interest expense: |
$160,023
|
$704
|
| |
| With additional principal payment
of: |
$200
|
$ 200
|
| Remaining loan term (months): |
222
|
25
|
| Total payments: |
$248,226
|
$15,479
|
| Total interest expense: |
$98,226
|
$479
|
| Interest savings: |
$61,797
|
$225
|
Making additional principal payments on your house
for almost two decades will obviously save you a lot more money
than making additional principal payments on your car over the next
two years, but before you get too carried away with the idea of
making additional principal payments make sure there's no prepayment
penalty on the loan.
The decision isn't always about comparing what you
can earn in investment returns vs. your effective interest rate
on your loans. If you don't have an emergency fund with liquid funds
equal to three to six months' worth of living expenses, then that's
where you should start putting this money.
With no company match in your 401(k) plan, you may
be better off in the long run to contribute to a Roth IRA. While
the 401(k) defers taxes on contributions and investment earnings
until they are withdrawn as qualified distributions from the account,
the Roth IRA is funded with after-tax dollars, but the investment
earnings are free of federal taxation. Talk to your tax professional
about whether you should be contributing to a Roth IRA as part of
your retirement savings plan.
If you're more than 10 years from your planned retirement
date, I'd much rather see you investing toward your future financial
goals than prepaying the mortgage or car loan. Over a longer investment
horizon, you shouldn't have any problem earning more than the effective
rate of interest on your loans. If you're putting the money to work
in a 2-percent certificate of deposit, then that's a different matter.
|
