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Mar 28 2011 12:00AM

Question


We’ll be getting a large tax return of more than $12,000 and — aside from adjusting our W4s — we want to know what to do. We already invested $25,000 or so into our 401(k)s and we have a first mortgage with a fixed rate and home equity line of credit that has a balance of $40,000 with a variable interest rate currently at 3.74 percent. The issue is we don’t have much of a nest egg. Should we pay down some of the equity line and use that line of credit as a nest egg or put the money into a regular brokerage account for a nest egg? Or do we pay off our car loan, which has a balance of $5,000 and an interest rate of 5.5 percent, and then add more to our retirement account? I also have a Roth Individual Retirement Account (IRA).

Answer


FPA member Eric C. Roberts, CFP®, of Pathway Planning Group, said the following:

“When you refer to a ‘nest egg,’ it sounds as if you are referring to an ‘emergency fund’ or an account that is very liquid with no risk of loss of principal. I would not rely on an equity line of credit to serve as an emergency fund because it may not be there when you need it most due to the credit line limit being lowered or closed all together. I would use a bank savings account or money market account where I had access to it easily during an emergency. By emergency, I am referring to an event like a job loss. I would set aside monthly expenses from between three to nine months, depending on how risky your income stream is and how comfortable you feel. If that can be covered and there is more left over, I would then pay off the car note next. Or if you would like a route with an immediate change to your monthly bills, pay off the car note, put the rest in an emergency fund and direct the amount you are saving from not having to make the car payment into the emergency fund until you are up to the level you set for yourself.”

Meanwhile, FPA member Eric Dunavant, CFP®, president of Dunavant Wealth Group, said that it’s difficult to provide a complete answer without knowing your age, income, and current amount of savings. That said, below is the guidance he offered:

“Congratulations on putting away $25,000 in your 401(k)s. That is a great step towards your long-term wealth. My personal bias is to encourage individuals to eliminate as much unsecured and variable debt as possible. Based on your refund of $12,000, I believe the following course of action would be most prudent.

  1. Pay off the car at 5.5 percent.
  2. If you have not already done so, set aside a portion of the money as a “rainy day” emergency fund. While you still have the variable debt on the equity line, I would put no more than one month of your bottom line expenses into this fund.
  3. With the remaining funds, pay down as much as possible on the home equity line of credit. 

“It is important to build your ‘nest egg’ savings, but I have found that once an individual has eliminated unsecured and variable debt, they typically have a faster rate of accumulation and more intensity towards that goal.”

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