investing

Know rules before paying off car loan

Don Taylorq_v2.gifDear Dr. Don,
I own stock in IBM. My father purchased 13 shares for me in 1982 (I believe) and these shares have "split" twice, giving me a current total of 52. Despite the rocky economy, this stock has weathered it well and the value now exceeds the $5,900 loan balance on my car. It's a 2007 Honda Civic and is financed at 5.8 percent.

While I can handle the $260 per month payments, I am sorely tempted to cash out that stock and pay it off, but I'm not sure if I should do so. I'd love to have the extra breathing room and own the car outright. What do you think?
-- Julie Jalopy

a_v2.gifDear Julie,
Presuming there's no prepayment penalty on the auto loan and the car wasn't financed under an arcane method of computing interest called "the rule of 78s," I think you can reasonably justify a decision to sell the shares to pay off the car loan.

However, before you do, read the Bankrate feature "Rule of 78 -- Watch out for this auto loan trick" and your loan documents to check on this. Ask your lender if you can't tell by reading your loan documents.

One benefit of selling the shares now is you can be fairly certain about the capital gains taxes you'll owe on the sale. There's always a risk that the tax rate can change with time. The Bankrate feature "New capital gains rate: zero" explains the current tax laws and treatment of long-term capital gains.

It's important to ask yourself what you'd do with the $260 a month you've freed up in your monthly budget. Ideally, you'll use most of that money to build an emergency fund, finance some retirement savings or pay down some other debts. Selling the stock to free up an additionally $260 a month in spending doesn't make sense unless you're between a rock and a hard place, and from what you've written, you're not.

You're weighing the financial flexibility of having an investment reserve against the financial flexibility of how you allocate income in your monthly budget. It's not a bad trade if you have the discipline to not let spending ramp up for current consumption.

None of my commentary reflects an opinion on the prospects for IBM stock. It may go up, it may go down. If you do sell the stock, you'll have the certainty of owning your Honda free and clear. Your basis in the stock -- the price used in calculating the capital gains -- is likely to start with what your father paid for the shares, adjusted by the subsequent splits. You'll want to work with a tax professional to establishing the tax impact of selling the shares.

Read more Dr. Don columns for additional personal finance advice.

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