Best use for inheritance: pay debt or create savings?
By Sally Herigstad | Published: March 5, 2010
To Her Credit
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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