Pay off debt AND fund your IRA
A reader with big credit card bills has extra cash. But Money's Walter Updegrave says not to put it all toward debt.
NEW YORK (Money) -- Question: I pay $300 a month on my credit-card balance of roughly $11,000. I have an extra $350 a month that I can use to further reduce my credit-card balance, or that I can invest in a Roth IRA. Which will give me the biggest bang for my buck? - William Scott, Spotsylvania, Virginia
Answer: The short answer is that you would almost certainly be better off using the extra dough to pay off your credit-card balance.
That said, however, this is one of those areas where the best deal in the strictest financial sense may not necessarily be the best real-world solution.
To see what I'm getting at, let's run through a scenario using the figures you've given me, and then I'll explain why you might not want to make your decision purely on the numbers.
You don't mention what interest rate you're paying on your credit card, but for argument's sake let's assume that you pay 14 percent a year, which is roughly the national average. As for the Roth IRA, let's figure that you earn 8 percent a year, not a spectacular return, but a reasonable one assuming you invest in a diversified mix of stocks and bonds.
Investing extra dollars
Let's first look at the scenario of you continuing to pay $300 a month on your credit card and then investing the extra $350 in a Roth IRA.
At a payment rate of $300-a-month, it will take 49 months to wipe out an $11,000 balance on a card that charges 14 percent a year, according to the credit-card calculator at Bankrate.com. Actually, your last payment will be just over $38, leaving you with just under $262 of the $300 you set aside for that final payment.
Now, if at the same time you're paying $300 toward your credit card bill, you also contribute $350 a month to a Roth IRA that earns 8 percent a year, after 49 months you will not only have a zero credit card balance, you will also have investments worth $20,215 sitting in your Roth IRA account.
And if we assume you're conscientious enough to throw in the $262 or so you had left from your last credit card payment - and that you earn a month's return on that money - then your Roth IRA balance would total $20,479.
Not bad. But let's see how you would fare if you had instead paid off the credit card as quickly as possible and then funded the IRA.
Paying off debt
In that case, you would devote $650 a month to the credit card - your current $300, plus the extra $350. At that payment rate, you would clear your balance in just 19 months. Your final payment would be just under $626, leaving you with about $24.
After paying off the credit card, you would then have $650 a month to invest. You can't put the entire $650 a month into a Roth IRA, however, since you would exceed the maximum annual contribution of $5,000 for 2008. (People 50 and over can make an additional $1,000 catch-up contribution, but I'll assume you're a youngster.) But you could stash $416 a month in the Roth (which takes you to the $5,000 limit) and invest the remaining $234 a month in a taxable account. (See editor's note at bottom.)
If you followed that regimen for 30 months - and earned an 8 percent annual return on your monthly investments plus the $24 left over from your final credit card payment - you would have about $13,800 in your Roth plus another $7,600 or so after taxes in your taxable account (assuming a 28 percent annual tax rate), giving you a combined after-tax balance of roughly $21,400 at the end of 49 months.
Bottom line: By using all your cash to pay off the credit card first and then investing the entire $650, you would come out ahead by a bit more than $900 (a margin that could easily go to $1,000 or more if you invest more tax efficiently in the taxable account).
This result isn't too surprising. By paying off the credit card first you're reducing the amount of time you're being hit with a 14 percent annual interest charge. That's effectively the same as earning 14 percent, which is more than you're earning on the money you invest. (Of course, you could arrive at the opposite result by assuming you'll earn more than 14 percent on your investments, but I think that would be unrealistic.)
Downside of clearing balance
As I said earlier, however, I believe there's a potential hitch in the strategy of zeroing out your credit card balance before you begin to invest. My concern is that you might never get around to paying off your credit card. Sometime over the year-and-a-half or so, you could lose the resolve to clear that debt and begin finding other ways of spending the extra $350 a month.
In short, I worry that someone in your position who embarks on the "best" strategy might find themselves a year or two later still owing substantial credit-card debt but never having gotten around to funding the Roth IRA and investing in the taxable account.
That's why I think the less-than-ideal strategy of continuing to pay off the credit card, but simultaneously plowing money into the Roth, might actually be the better way to go since that approach at least gets the Roth IRA up and running quickly.
Upside of funding Roth IRA
Granted, this strategy can also fizzle. I could easily imagine someone making just a few of Roth IRA contributions and then neglecting to follow through in subsequent months. But starting the Roth right away while you've got the urge to improve your situation might get you into the habit of saving regularly (especially if you sign up for an automatic investing plan that moves money regularly from your checking account to a mutual fund). And even if that doesn't happen, well, at least you'll have some money in a Roth IRA that can come in handy at retirement.
So my advice is that if you're really, really sure that you've got the discipline to pay off your credit card and then fund that Roth IRA and the taxable account, go for the "best" strategy.
But if you're not positively absolutely sure, then I think it's a perfectly acceptable strategy - and probably the more sensible choice - to pursue both goals at once and pay off your credit card while funding the Roth IRA.
Debt free is best
By the way, for those of you out there wondering whether you're better off devoting extra cash to your credit card or your 401(k), the answer is basically the same. Based on the numbers alone, you're generally better off eliminating the credit card debt first, although matching funds within a 401(k) can complicate things. (For a more detailed answer for the 401(k) question, as well as answers to five other common financial queries, click here
Of course, an even better strategy for achieving financial security and assuring yourself a comfortable retirement is to avoid running up unnecessary and burdensome credit-card debt in the first place. That way, you can funnel whatever money would have gone to pay the debt on your plastic directly into your 401(k) or IRA.
Editor's note: An earlier version of this story incorrectly said that one could invest $650 a month into a Roth IRA. That's not possible, however, since there's a $5,000 limit for Roth IRA contributions in 2008. The current version corrects this error by splitting the $650 between a Roth and a taxable investment.
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