Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006). She writes "To Her Credit," a weekly reader Q&A column about issues involving women, credit and debt, for CreditCards.com, and also writes regularly for MSN Money, Interest.com and Bankrate.com, and has guested on Martha Stewart Radio and other programs. See her website SallyHerigstad.com for more personal finance tips and free budgeting worksheets. Ask Sally a question, or read her previous answers in the To Her Credit archive
Dear To Her Credit,
I recently inherited a small amount of money. I paid off my
credit cards and am considering paying off my car. My current interest rate is
11.5 percent. If I pay off this loan I will be debt free, but I will only have
$7,000 left in savings. What should I do? -- Sharon
You were smart to pay off your credit card bills, especially
if you can pay your balances off every month from now on.
If I had to give an up or down vote based on just what you've
told me, I'd say pay off the car. Put the amount of your former car payment
into a separate savings fund for your next car, and vow to never again make
payments on anything except your house.
Never having car payments can make the difference between having
a rather comfortable financial life and probably saving for a good retirement,
or always just scraping to get by. According to Richard Jenkins in "Your 7 Biggest Financial Decisions," you could have $352,000 more at
the end of 35 years if you always save ahead for your cars -- and that doesn't
count the fact that it should be easier to keep your credit card balances at
zero if you're not struggling to make car payments every month!
Now for the caveats. I think $7,000 is a healthy savings
account, especially if you live in the Midwest where the cost of living is
reasonable. If you live in New York City or San Francisco, or if you have a
large family depending on you, $7,000 might only last a month if something
happened to your job. You should try to keep three to six months' living
expenses in savings. That's more important even than paying off your car.
If you want to keep more cash in savings, for example, if
there are rumors of layoffs at work or you have health issues, consider keeping
enough money in savings to last you one year if necessary.
If you can't afford to pay off your car and leave enough in
savings to make you feel reasonably secure, you have a couple of options. You
can put some of the money toward the principal balance of your car loan and
then pay off your car as quickly as possible. Now that you're not making credit
card payments, you could also redirect that money toward the car payments. Or,
if you really want to get out of debt, consider selling the car and buying one
you can afford to get with cash.
One more caveat: Always contribute to your employer-matched 401(k)
plan, at least up to the point that you collect the full benefit. Employer
matching contributions may be the only place you can get a guaranteed better
return on your money than by paying off an 11.5 percent loan. If your employer
contributes 50 cents for every dollar you contribute, that's an instant 50
percent return. If you don't take advantage of matching retirement fund
contributions, you're telling your employer, "No, thanks -- keep the money!"
The money in your 401(k) plan is not totally out of reach if
you have an emergency someday. You can take distributions from a 401(k) plan or
other retirement plans in certain cases such as disability, unemployment, major
medical expenses or divorce settlement. Yes, in some circumstances, you'll have
to pay a 10 percent penalty. However, it's better to possibly face a 10 percent
penalty later than to give up a 50 percent return now.
You're doing well to use this money to pay off debts and
make sure you have a solid emergency fund. Use this chance to get out of debt --
and to stay that way the rest of your life.
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