Odds are, you're better off retiring debt with a windfall

Sure, you could save it, but paying off high-rate loans is your best bet

By Gary Foreman

The New Frugal You

Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. Ask a question. 'New Frugal You' archive

Dear New Frugal You,
I've had a sudden one-time $5,000 windfall due unfortunately to a relative passing away and leaving me some money. I've got a car that's nearly paid off ($1,000 to go) and about $4,000 in credit card debt that I'm able to pay more than the minimum on, but only barely. Do I just make the debts go away, or is it better for me to save it? I currently have a 401(k) that I put 5 percent into and have 30 years to go to retirement.
-- Sudden Wealth

Dear Sudden,
I'm happy that you've received a windfall, though I'm sorry that it had to come under those circumstances.

Knowing what to do with a windfall is very important. It's tempting to pack an overnight bag and take that trip to Vegas you've been dreaming about! A few spins of the wheel or a little sharp card playing -- thanks to that new "foolproof" blackjack system you've got, right? -- and you might be able to retire. But just for the sake of looking responsible, you probably should consider the alternatives before you book your flight.

It's a little hard to compare paying off debts to saving money for retirement. Kinda like comparing a roulette wheel to playing draw poker. The best way that I know is to compare what option gets the best return on your money. Fortunately, the good news is that usually you don't even need to find a calculator for the math.

Think of it this way. Are interest rates usually higher when you borrow money (think car loan, credit card bills, your mortgage)? Or are they higher when you're earning money (CD rates, return on your 401(k))? The rates are almost always going to be higher when you borrow. So you'll get the best return by paying off debts instead of investing.

And, if you're trying to compare which one of your debts to pay first, always pay the one with the highest APR. It's just that simple. Whether you have five grand or just a couple of extra bucks from hitting the office March Madness pool.

What about other factors? In this case, it's possible that your employer might match his 401(k) contribution. That would be like hitting the quarter slots! But, even then you can calculate how much your investment will earn.

If you're a math geek, just multiply the amount being invested (in the 401(k) or toward paying off debts) by the rate of return. Look on your 401(k) and credit card statement for the rate. That will give you a fair comparison.

Now occasionally an investment, like your Vegas trip, will look really promising. In that case, you'll want to compare the potential return to the interest rate on your debt.

I seem to be having trouble getting a number on how much that blackjack system could pay. The best I can find is casino earnings for 2009. According to the Las Vegas Review-Journal, there were $10.3 billion in gaming revenues in Nevada in 2009. I'd have to assume that money came from guys like you and me.

What I can't figure out is how they can make so much money when guys like you and me are hitting the jackpot at their tables. Maybe if I think about it a little more it'll all make sense to me...

See related:  Control your financial life

For more than 35 years, Gary Foreman has worked to help people get the most for their money. Prior to founding The Dollar Stretcher.com, he was a financial planner and purchasing manager. Gary began The Dollar Stretcher website and newsletters in April 1996. Today the website features more than 6,000 articles on different ways to live better for less. Gary has been interviewed by The Wall Street Journal, The Nightly Business Report, USA Today, Reader's Digest and other newspapers and magazines. Gary answers a question about a budgeting or saving issue from a CreditCards.com reader each week. Send your question to The New Frugal You.

Published: May 27, 2010

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