A lot of people that I know have very strong feelings as far as whether to use "extra" money left over each month to either pay off debt, or to put into investments.  It's a no-brainer to pay off an 18% credit card, because in most cases, you will not be able to find an investment that will have that high of an interest rate.  But what if you were considering paying off a 5% car payment, and you had an investment opportunity to earn 7% during the same time?

 

The trick is to maximize your money by knowing your capital gains tax.  For the 2008 tax year, if you are in the 10% to 15% income tax brackets through 2010, you will be paying 0% for long term capital gains taxes.  If you are in any of the higher brackets, you will be paying 15% for capital gains taxes.

 

I have created a Debt vs. Investing Spreadsheet, to make the calculations easier.  I've also created the example below to show how the calculations are figured.

 

Example.  Lets say we have $5000 in principal left in our car payment at 5% per year, but we have that 7% investment that we are considering.  We also would rate for the 15% capital gains tax.  Which would be the best place for our $5000 that we will have left over for the year?

 

First, we look at paying off the car, which would be

 

   Car             Interest rate              Savings

  $5,000   x          5%                =      $250

 

Now, for the investment:

 

   Principal    Interest rate               Gross Income          Capital gains tax              Net income

   $5,000    x       7%                =             $350           x        (1  -     15%)           =         $297.50

 

In this example, you would invest.  If however the interest on your car were 6% instead of 5%, your savings would be $300, which would tell you instead to pay off your car.  The difference between investing and saving in that case is only $2.50 for the entire year.

 

As you can see in our example above, a 2% difference in interest rates would yield us about $50 for the year.  While not a lot of money, doing this sort of calculation over the course of years can add to a pretty significant amount.  Also, you must remember to keep up with the IRS changes regarding capital gains taxes.  As of this writing, they plan to allow long term capital gains taxes for many individuals to go back to 20% before the year 2011.

 

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