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Financial Life Advisor
What To Do With A Windfall On A Tight Budget
I work for a county government that is thinking of decreasing my income as part of its new budget. As a county employee, I have a strong retirement program but currently own no real assets free of debt aside from my car (which is likely not worth much).
I recently bought a house and owe about $110,000 on it and owe about $80,000 in student loans. With the projected pay cuts, I think I am going to be very near in the red considering my current monthly expenses. Let us say I just matched 5 numbers on a lottery and won about $100,000, which is currently sitting in a bank account. It is not enough to pay off the house, and I worry about paying off student loans while having outstanding secured debt. What is the best way to make my money work for me? Paying off loans or investing in something?
R.P. from San Antonio, TX R, you highlight one of the big tradeoffs of working for government. You usually have a good retirement plan and benefits, but the pay is typically a standard schedule with little or no control on your end. Usually, though, the government does not have to resort to employee pay cuts. If your county government were to do that, I suspect you would not be the only employee squeezed financially. Most Americans have a significant portion of their paycheck devoted to payments like their house, car, and school loans, and when there is not much discretionary income left over at the end of the month, a decrease (of any amount) in pay can be difficult.
To answer your question about the $100,000 windfall, my recommendation is pretty clear in my mind: Interestingly enough, my recommendation was not even offered as a potential option in your question. I will try to walk you through my logic.
The first thing you said was that you are facing a potential pay cut at work. This event could create a situation in which you might not even be able to cover your fixed expenses. A monthly cash shortage is of huge concern to me as a financial planner. Getting behind in debt payments is usually accompanied by interest rate hikes, late fees, penalties and potentially, a repossession or foreclosure. Any of those events would mean you could lose even more money. If you were strapped before, those types of events can spell bankruptcy. Avoiding a cash flow crunch is my first priority, paying off debt and investments come second. You should also consider that lotto winnings will be taxed at ordinary income tax rates. The worst person to owe money to is the IRS. Make sure to set aside enough of the winnings for the increased tax bill. Paying a tax expert may be worthwhile.
After breaking off Uncle Sam’s piece, the next thing I would recommend is to take an amount equal to three times your monthly expenses and put that cash aside in a separate high yield savings account. That is your insurance policy in case something goes wrong. You mentioned that you recently bought a house. If it has not happened already, you will soon find out that one of “joys of homeownership” is that you get big, fat repair bills unexpectedtly. Even if it is not your house which is the source of a large expense, life has a funny way of throwing unexpected expenses your way and when you are just getting by financially those surprises can be financially devastating.
Once your emergency fund (3 months expenses) is taken care of, the next question would be whether to pay off debt or invest. To reach a decision, we need to understand some basic investing concepts of risk. The first thing you should consider when comparing two different investments is how they compare to each other. Not all investments are created the same and it is important to recognize when you are comparing apples to apples or if you are comparing apple to oranges.
Although investing in a bank CD and launching your own business are both investments, they are not equal. One is basically risk-free (the bank CD), and the other has a good chance of losing 100% of your investment. How, then, should one decide how to invest? Finance academics have several measures for risk. I will not bore you with the details, but the premise is that one way to evaluate risk of an investment is to compare the expected rate of return to the risk-free rate of return (RF-RoR). The difference between those numbers is the risk premium being paid to use the capital of the investor. An FDIC insured CD or Treasury Bill (T-Bill) are good examples of a risk-free rate of return benchmarks you can use.
For instance, let us say you invest in a CD at your local bank. They are paying 3% interest on the CD. If the bank goes under, the Federal Government steps in to make good on the CD. This could be used as a benchmark for the RF-RoR. If you invest in an AA rated bond from a large corporation which has a very high credit rating, you will get a higher interest rate. For this example let us say it is 5%, which means you would be earning 2% more than the RF-RoR. This 2% represents the risk premium you are being paid for the higher risk in the corporate bond. If that large corporation goes under, you are simply a creditor who may not get your money back.
After all, why would you as a rational investor put your money at risk if you could earn the same interest without risk? Let us take this a step further and assume you are looking at investing in a company in the a 3rd world country. A very risky choice. What potential rate of return would you expect to get for risking your money? The value of the investment could swing wildly, and you could lose it all. Here you would expect a much higher rate of return than the RF-RoR. Perhaps you would need to earn 20% per year to risk your money. You would need to have the opportunity to make big money for making such a risky investment. The risk premium for the 3rd world company would be 17%.
Expected Market Return Risk Premium
CD (RF-RoR) 3% 0%
AA Corporate Bond 5% 2%
3rd World Company 20% 17%
When looking at your student loans and mortgage, they are sort of like a risk-free rate of return. If you pay down the debt it will automatically save you the interest you would have had to pay on the debt you just paid back. To put it another way, if you do not have that debt, then it is like you are getting a guaranteed rate of return on your money because you are not paying the loan interest anymore. By extension, if your mortgage or student loan interest rates are higher than a CD rate, you are probably better off paying down the debt first. You are in effect getting a higher risk-free rate of return than the general market is giving you. If you had a 6% mortgage and you could earn a 10% RF-RoR, then I would say invest it. It is more likely you are paying 6% on your mortgage and the RF-RoR is more like 2% right now. If you invest the money you are taking on additional risk. The tax you would have to pay on your investments in effect raises the cost (risk) of investing.
So which do you pay down first, the mortgage or the loans? Interest on both is generally deductible for income tax purposes. I am assuming that your income is not high enough to phase out the deductibility of student loan interest. Another consideration may be how overpaying either debt would affect the regular payments being made. With a credit card, as you pay the balance off, the required payment amount decreases. With both the student loan and mortgage, this is not the case. A larger portion of the scheduled payment is applied to principal in both cases and the monthly cash payment amount is the same.
In light of these considerations, I am going to recommend you pay down whichever has a higher interest rate. If the rates are relatively close, I would opt for the student loan first. As your income rises, this interest might not be deductible anymore. Additionally, because it is not collateralized, you cannot sell an asset to pay off the student loan. In a worst case scenario, you could sell your home and get a cheap apartment to free up cash flow.
You did not ask this in your question, but here are some potentially helpful ideas I have after thinking about your question. You could consider taking on a roommate to help defer housing costs. Also, if the county does not restrict it, you could also consider taking a second job on evenings and weekends or doing some sort of consulting on the side.
I have a feeling the current economic malaise will pass and you will get through this. Congratulations on the home purchase. If you need any more advice do not hesitate to ask.
Posted by Ben Gurwitz on 16th October, 2009 | Comments | Trackbacks
Tags: Financial Planning, Debt Management, Oct 09
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