Mellody gives advice on how you should prioritize your debt, and the best use for $1,000 right now.
I recently inherited $1,000. I have credit card debt, student loans, but I also want to invest some money. What should I do first? – Gary, Philadelphia PA
The most important thing you can do right now is pay down your high interest debt, which for most people is their credit card debt. The average annual percentage rate (APR) on a credit card is currently 14.48%, and the average American has $4,200 in credit card debt.
So let’s do some math. Let’s say you have the average debt amount of $4,200 at the average APR of 14%, and you are paying the minimum each month of about 4%. It would then take you 114 months (more than nine years) to pay off the debt, and you will pay an extra $1,646 in interest. Now let’s say you took that $1,000 and put it towards your balance, so you only owed $3,200. Even if you paid the minimum, it would now take you nine less months to pay off and you would save $400 in interest.
So should I pay off my student loans versus paying off credit card debt or even saving?
Good question. The average student now graduates with $24,000 in student loans, which is definitely a lot of money, but I have an answer that may surprise people. Don’t worry too much about your student debt, because it is at a much lower interest rate than most of your other debt. For example, a Stafford loan is currently 6.8%. I would even invest before I consider putting more towards my student loans. Over the long run, your return from investing the money will most likely be greater than saving a few dollars on your student loan.
So if I have taken care of my debt, is it time to move on to investing?
Not so fast, don’t forget about your rainy day fund for all of those unpredictable events. A recent State Farm survey found that 35% of respondents only had funds to meet their financial needs for 3 months or fewer. This is really bad. I always say you should have at least 3-6 months worth of cash stashed away for unexpected events. This has become even more important with our current sluggish job market.
Once I save for my rainy day fund, what should I do next?
The next thing to do is save for retirement. Think about increasing your investment in your 401k or Individual Retirement Account (IRA). Remember if you are over 50 there are catch-up provisions for your 401k and IRA. With 401k’s you can invest $5,500 more than the $16,500 limit and with IRA’s you can invest $1,000 more than the $5,000 limit. If you have not been saving until now, and you are over 50 make sure you try and put away as much as possible.
Also don’t forget about the stock market. If you look at when the market bottomed on March 9, 2009, it is up over 75% since then. So, let’s look at that $1,000 again. Let’s say you take that $1,000 and you get an 8% return every year, and you don’t invest another penny, then in five years, you will have about $1,500, and in 25 years you will have over $7,300.
So is it ever okay to spend the money?
Of course it is, but unfortunately there is no magic formula for how much should go towards savings, versus paying off student debt, versus actually spending the money on that new pair of shoes, because it is all relative. If you are someone who can afford to splurge a little because you are saving the right amount and you do not have much debt, then I would say go ahead and buy that new pair of shoes. But, if you are someone that will really need the money then make sure you take care of your needs first before your wants.
Also if you have a few dollars left over, and buying your 40th pair of shoes is just not that appealing anymore, then think about donating it. There are great websites out there like charitynavigator.com that can help you make sure you get the most bang for your buck.