Dear Dr. Don,
My debt consists of six years left on a 15-year fixed-rate mortgage at 5 percent with a balance of $40,000. I also have a home equity line of credit, or HELOC, that is interest-only at 4.125 percent with a balance of $30,000. I have $25,000 in credit card debt at interest rates of 5.9 percent and 7.9 percent.
I will be receiving about $35,000 this summer from an inheritance. My credit is excellent, and my home value is about $140,000. I’m planning to retire in about 10 years. What would be the best plan to get my financial house in order?
— Sam Selects
What makes you think your financial house isn’t in order? You have 50 percent equity in your home, no car payments, and your credit card debt, while on the high side, is at interest rates that would make the typical borrower with $25,000 on his credit cards green with envy.
You just need to decide what to do with the money you inherit. My leaning with an inheritance is to do something with it that will make lasting change in your life. Paying off your old debts doesn’t do it for me, but it may be just the thing for you to make that change.
My rule of thumb is you use savings — in this case your inheritance — to pay down debts when the effective rate of interest on your loan is higher than the after-tax interest on your investments. Assuming you’re able to fully utilize the mortgage interest deduction on your income tax return makes the effective interest rate on your mortgage and HELOC fairly low. That would point to using the inheritance to pay down your credit card debts instead.
Why that instead of investing? Well, if you pay 15 percent income tax or capital gains tax on your investments, you’d have to earn more than 6.94 percent for the lower interest rate card balance and 9.29 percent for the higher interest rate card balance to beat the strategy of paying down your credit card balances.
After paying down the credit cards, you still have $10,000 available. You could decide to invest it for the future, or use it to make an additional principal payment on your mortgage. If you’re anywhere close to retirement, use it to pay down the mortgage. Then, work on living within your means and not running up big credit card balances.
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