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Oct 24 2011 12:00AM

Question


Due to unemployment, I have debt on two credit cards that equals about $16,000. I have student loans that equal $25,000. And lastly, a personal loan from a friend with zero interest at $10,000. I have access to a $20,000 windfall that was set aside for an investment in a house. Should I use this windfall to pay off half my debt? I also have two Individual Retirement Accounts (IRAs) with around $3,000 in each. Should I liquidate one of those accounts and use the money to pay off the debt as well? I have no cash savings. It was used up while I was unemployed. I am a freelance designer and never qualified for unemployment benefits. However, I am now an employed freelancer full time with no benefits. Thus, I’m stuck using all my extra cash towards my credit card/loan debt.

Answer

“The first things that jumped out at me from your question were 1) you need to purchase health care coverage, and 2) you need to establish an emergency fund (maybe three months' living expenses),” said FPA member Timothy Sobolewski, CFP®. “Ideally you should begin to do this out of your current income, but it could make sense to use part of your windfall to get this started if need be.

“The next thing to tackle would be your credit card debt, assuming that you're paying the usual substantial interest rate on the balances. You should use part of your windfall to pay this down, which would reduce the minimum monthly payments that are currently gobbling up your paycheck; then continue to pay more than the minimum if you can. There is now a required disclosure on your card statements that will show you how much you could save by paying off the balance early. 

“What you should NOT do is withdraw from your IRAs. Between taxes and early-withdrawal penalties (I'm assuming here that you're under 59 1/2), this would be a very expensive source of funds.

“Continue to pay your student loan as you have been. As to the private loan from your friend, it may be wise to attempt to repay part of this, depending on the understanding that you have, even though you're not being charged interest. You don't want the ultimate cost of the loan to be your friendship.

“Although you said the windfall was intended for a future home purchase, you would need to pay down debt anyway to qualify for a mortgage. There will be time to save for a home later, after you're on a better financial footing.”

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