Dear Debt Adviser,
I have just received a $20,000 inheritance from a relative that recently passed. As it turns out, my wife and I have about $20,000 in credit card debt with the monthly payments adding up to around $500. We also have a car loan with a 7.99 percent interest rate and a payment of $531 a month. The payoff amount on the car is $19,500. Which is better to pay off, the credit card debt or the car?
The phrase “don’t spend it all in one place” popped into my mind as I read your e-mail. It was quickly followed by “don’t let that money burn a hole in your pocket!” Your goal to pay off your outstanding debt with your windfall may be a good one. However, I’d like to ask you some things before I comment on the best use of the money. First, I’d like you and your wife to ask yourselves where did the $20,000 of debt come from? And is there likely to be more in the future? I’ve seen larger credit card debts, but $20,000 is no small number. I don’t know how you came by this little bundle of gloom, but I want you to be sure it doesn’t just reappear in a year or two.
Once you and your wife have an understanding on this matter, then my next question is: Do you have an emergency savings cushion of six months’ to a year of living expenses? The best way to avoid large credit card debt is to have money set aside for those unexpected or large periodic expenses that your regular paycheck alone can’t cover, like taxes or new furniture. If your answer is no, you do not have an emergency savings cushion. I would recommend putting at least half of your inheritance into a savings account with limited access.
Next, you didn’t mention your age, but if you are in your 20s or 30s and you haven’t already done so, I would contribute the maximum $5,000 to an IRA. I know you will likely earn less in interest on this money than you are paying on your car loan and credit card accounts, but what you will gain is the magic of compounded interest over time. Time is something that you cannot purchase for funding your retirement planning, so if you have it, I say take advantage of it.
Now, for the answer to your question, due to the nature of cardholder agreements, (most can be changed by the card issuer), I believe if I were you I’d pay off the credit cards. The Credit Card Accountability Responsibility and Disclosure Act of 2009, or Credit CARD Act, will protect you from some of the major negatives of cardholder agreements such as universal default, but you will still have a variable interest rate loan with an amendable agreement that could be changed, and not usually in your favor.
The caution that comes with my advice is that it is imperative that you have the discipline to stop living beyond your means once you have cards with zero balances again.
Assuming you don’t spend the inheritance on lottery tickets or a weekend in Vegas, there are no wrong answers here. If you are uncomfortable with the amount you owe on your car loan, particularly if you are currently upside down (owe more than the car is worth) on your loan, then you might consider using some of the money to pay down the note so it is equal to or less than the book value of the car. This will give you the option of selling the car without coming up with a chunk of cash, should the need arise. Before you take this action, be sure you do not have a penalty for early pay off included in your loan terms.