What to Do with a Windfall

Question of the week:We've just received an unexpected windfall of $10,000. My wife says that we should invest it, but I want to pay down some debt. Which do you think is best? --Russell from Tampa

Dear Russell,

Yours is one of the classic dilemmas in personal finance. We posed your question to members of the Armchair Millionaire community. Some advocated paying down debt, others the investing route. And others, like this one, advised a little of both:

"I would break it down into four buckets of $2,500 each. I would pay some credit card debt, put $2,500 in my emergency fund, invest $2,500 in either individual stocks or a stock mutual fund and I would spend $2,500 on something fun for me." --Mattchiavo

Either way, you'll get a return on your investment. The question is which offers the best return. To run the numbers, you'll need to look at the interest rate on your debt and figure what you would save in interest, as well as assume an annual rate of return on the investment you might make. And you'll also have to figure in the impact of the taxes (if any) that you would have to pay on your investment returns.

Here's an example. Let's assume you're paying 15 percent annual interest on credit cards, and that it would take you another five years to pay them off with your current payments. By using your windfall to pay them off immediately, you'll save $4,274 in interest over the next five years. On the other hand, if you invest that money in a tax-deductible account and receive an average annual return of eight percent over the same five years, you'd earn $4,898. Keep that investment over the next 20 years, however, and you'd earn $39,268.

However, the numbers don't tell the entire story. The best alternative will depend entirely on your own situation. My guide will help you make the right choice.

The Armchair Millionaire Guide to Choosing Debt Reduction or Investing

• What kind of debt is it? Some kinds of debt are better than others. A mortgage, for example, is a far cry from high-interest credit card debt. The interest rate is lower, the interest may be tax deductible, and that debt allowed you to buy an asset that's likely to increase in value over the years. On the other hand, credit cards have high, non-deductible interest and are often used for one-time purchases, like dinner out or a tank of gas--things that are gone long before we even pay for them.

• Do you have a plan for avoiding future debt? If you pay down your debt but then immediately run up your credit cards again or take out a new loan, you'll have gained little for the long term and will have lost a great opportunity to invest.

• Do you have a good place to invest the money? If the stock market doesn't look attractive to you right now and your investing alternatives are a low-yielding money market fund or CD, you're probably better off paying off the debt. But if an investment in the stock market looks good to you, this could be the better route.

• Can you make the money go even further by investing it? If you can tuck your extra money away in a 401(k) or tax-deductible IRA over the next couple of years, you'll enjoy a nice tax break in addition to your investment returns. You'll do even better if you employer matches some portion of your 401(k) contribution.

THE BOTTOM LINE: Financial windfalls are as rare as blue moons, so act carefully. Take time to weigh your options and arrive at the one that will have the best impact on your long-term financial health.

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