Dear Dr. Don,
I'm 32 years old and will soon be receiving a gift of $15,000 from a grandparent. I have a recent five-year, $16,000 car loan at 5.29 percent and 14 years remaining on a mortgage at 4.75 percent with a $96,000 loan balance and I have about $80,000 in home equity. I would like to best use this money, but am unsure if it is most wise to pay off the car loan, apply it to the mortgage or invest in an index fund. What might be the best route?--
The key is what you can earn on an after-tax basis if you invest the money vs. the effective interest rate you're paying on your debt. If you can use the mortgage interest deduction on your income tax return, then the effective rate on your mortgage debt is 4.75 percent x (1 - marginal federal income tax rate). That's about 3.56 percent if your marginal rate is 25 percent, but is even lower if state and local income taxes come in to play.
A home equity line of credit to pay off the car loan can make sense, again assuming you can use the mortgage interest deduction on your taxes. At this writing the weekly national average for HELOCs as reported by Bankrate is 4.75 percent, making the effective rate on your HELOC the same as on your first mortgage. Regardless of whether you prepay or refinance, make sure the car loan doesn't have a prepayment penalty or have interest calculated based on the
Rule of 78s before paying off the existing loan.
If your household budget isn't stretched, investing the money makes more sense than paying off the car or paying down the mortgage. Where's the extra $300 a month in your household budget going to go if you pay off the car?
Look at tax-advantaged retirement accounts, especially if you work and your employer has a 401(k) plan with the company matching some part of your contributions. That's free money to go with your free money. You can't put the gift in the 401(k), but you can use the gift to make room in your paycheck to contribute to the 401(k).
Alternately, between contributing for the 2004 tax year and the 2005 tax year, an IRA or Roth IRA account could, if you're eligible to contribute, allow you to invest nearly half of the gift. Contributing either to a Section 529 college savings plan or Coverdell Education Savings Account is also a good idea if college savings is one of your financial goals.
No one knows if the stock market will outperform your effective cost of debt on an after-tax basis, but the longer your investment horizon, the more likely it is that it will. A no-load mutual fund invested in a broad based market index is a sound investment choice for the long haul. You can use the
mutual fund search function on Morningstar.com to find a mutual fund that meets your needs.
Since your grandparent didn't write in for advice, I don't have to discuss the estate tax considerations of them gifting you more than the annual exclusion for 2004 of $11,000. The IRS publication on
estate and gift taxes has more information.