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This is one of the most common financial dilemmas.
You come into a windfall, and then debate whether or not to payoff debt, or to invest the money for the future.
Reader Katie asks the question this way:
“Hi Jeff – Congratulations! This is really exciting. A question I’m currently stewing over is this:
I’ve inherited some money that could get me out of about 85% of my credit card debt that I’ve been carry for ~8 years. My APR is 29%. Do I put it toward my credit card debt or do I look for other ways to invest it and start a cushion for my future?
Thanks for reaching out and encouraging us to ask questions.
All the best,
Katie’s dilemma is a bit more clear-cut than most. But I’ll start out by looking at it from a more general perspective, and then get more specific about her particular situation.
First Things First: Make Sure You Have a Savings Cushion
The question involving windfalls, and particularly inheritances, is almost always between paying off debt or investing. I would suggest that there is a third option that can’t be overlooked in a lot of cases.
Before you either pay off debt or invest for the future, the first thing you need to do is to create a cash cushion for the present.
One of the biggest reasons for financial stress – and even for the inability to achieve long-term financial independence – is a lack of liquidity. The absence of any kind of liquid savings forces you to rely on debt any time there is a cash shortage.
It doesn’t take much imagination to realize that an absence of savings is a surefire recipe for a lifetime on the debt treadmill. Unfortunately, it starts early with most people. Because they never have a basic savings account, credit dependency becomes a lifestyle. Debt can suck the life out of your finances, because it represents a perpetual drain on your income.
In addition, having enough savings to cover your living expenses for a few months will do more to reduce financial stress in your life than just about any other single strategy. It eliminates worry over an unexpected expense, or even a temporary loss of a job.
For all of those reasons, my recommendation would be to first make sure that you have enough money in a savings account or money market fund to cover your living expenses or at least three months. That will give you the breathing room that need to do everything else.
The Case for Paying Off Debt
Using an inheritance to pay off debt is usually a can’t-miss strategy. That’s because the rate of interest that you pay on debt is just about always higher than what you can in an interest-bearing account. For example, if you’re paying 20% on your credit card debt, but you can earn no more than 1% in a savings account, you’ll be losing 19% per year if you put the money into savings, rather than toward paying off your credit cards.
Still another factor is income tax. Interest earned is taxable, while interest paid on consumer debt is not tax deductible. That means that even if the spread between interest on debt and interest on savings were closer, the tax imbalance would continue to work against you.
Some financial advisors recommend that you eliminate consumer debt, particularly credit cards and other unsecured lines of credit, before you even begin investing. While I don’t necessarily believe that advice applies in all cases, it’s still a sound strategy.
After all, the elimination of a debt with a 20% interest rate effectively translates into an investment that pays 20% guaranteed!
There’s also an imbalance in regard to rate of return. For example, the interest rate that you pay on debt is usually locked in. But the return that you earn on your investments is not, at least in the case of equity investments, like stocks and mutual funds. In fact, those asset values can drop in a market decline, while your debt level will only fall to the extent that you make payments to reduce it.
Then there’s the point that by paying off debt, you free up your income for other purposes, including savings and investments. It’s often true that people who have a lot of debt are never able to save and invest. By paying off debt, you will be in a position to do just that, and that can change your financial life for the better forever.
You really can’t go wrong with paying off debt.
The Case for Investing the Money
A strong case can be made for investing an inheritance. This is especially true if you currently have no investments, and don’t have any history of having them.
Sometimes the money from a windfall can jump start you into investing. You get a basic nest egg to invest, and then you start adding periodic contributions to the account. The investment then grows steadily, through a combination of continuing contributions and investment returns.
Long-term, this is a sound strategy. Your wealth will grow along with the size of your investment portfolio. As you become wealthier, it’s entirely possible that your debt problems will eventually become smaller. That is, the amount of your investments can outstrip the size of your debt. When it does, you’ll be in a position to both pay off your debt, and still have investment assets for continued investing.
This can be especially true if the investing is being done through some sort of tax-sheltered savings, like an IRA, Roth IRA, or even a 401(k) plan. The fact that you have an inheritance can even free up more of your paycheck to contribute to an employer-sponsored plan.
In a tax-sheltered plan your investment value grows even faster, because there is no tax liability to reduce your rate of return. This is a way to build your investment worth quickly. And it goes without saying that it creates the kind of long-term financial stability that can improve your entire situation.
My Recommendation in Katie’s Situation
OK, the long and short of it is that Katie has three good options with her inheritance. In truth, she can’t go wrong no matter which she chooses. But I think there is an order here, or some options are better than others.
Katie hasn’t told us the size of the inheritance, or the amount of her debt. What she has told us is that the inheritance is insufficient to completely pay off her debt. In fact, she said that it would be enough to pay off 85%.
Based on those circumstances, I would suggest she choose the following – in order:
- Set up a savings cushion. The first recommendation is that she put enough of the inheritance into a savings account or money market fund to cover at least three months of living expenses. The fact that she has owed money on very high interest rate credit card(s) indicates that her financial situation is stretched pretty tight. The savings cushion will give her the room she needs to maneuver to seriously attack paying off her debt.
- Use the balance of the inheritance to payoff debt. Obviously setting up the savings cushion will leave her with even less money to pay off her debt. But it would also leave her in a stronger financial position. By using the remaining balance to pay down her debt, she will also lower her monthly debt payments. Any savings from those reduced payments should be applied to paying off the credit cards sooner. She should also look to find any other ways either reduce her spending or increase her income to pay off her debt completely.
- Begin investing only when the debt is paid off. Investing for the future has a lot of advantages, but in Katie’s particular situation I think that her priority has to be centered on improving her current circumstances. If she invests money immediately, she risks losing some of the money – without improving her situation. But if she creates a savings cushion and pays off her credit card debt first, she will be in a better position to throw everything she has at investing later on.
Katie, I don’t know if that’s the answer you were looking for, but it’s what I would recommend. You’re in a tight spot right now, and before you start investing for the future, you first have to secure present. Starting with the cash cushion, then paying off your credit cards, will enable you to do just that. Then you’ll have the rest of your life to invest away!