Updated on 09.16.14

Is Paying Off Debt With a Windfall a Good Idea?

Trent Hamm

moneyIn response to an earlier post on uses for a tax return, Dustin wrote:

I noticed that you didn’t have “Pay off debt” as one of the 10 things to do with your refund. Is there any particular reason you chose not to suggest that?

The reason that I didn’t suggest using such a windfall to pay off debt, especially credit card debt, is because in many cases it isn’t a healthy choice in terms of your relationship with money. Let me give you a typical example of what I’m talking about, using an example of a person I know with her name changed to protect her identity.

“Mona” likes to go shopping, and this past Christmas she went way overboard buying gifts for her nieces and nephews. She spent far more money than she had and racked up some pretty sizeable credit card bills, but that didn’t stop her from buying several new pairs of shoes at after-Christmas sales and also buying a new CD player for her car in March, all of which again went on the credit card. In short, she’s living way beyond her means.

Suddenly, in early April, a bill comes in and Mona realizes that she’s in a lot of credit card debt. She makes a minimum payment, but then she buys a few DVDs with her credit card and also goes out to eat a few times on the plastic.

Then, in early May, another credit card bill comes in – but so does a check from the IRS. She cashes that check and pays off her credit card.

What do you think happens to Mona after this? Is she suddenly going to start living within her means, not charging up her cards at all? Of course not! The check from the IRS became a new lease on her overspending life.

You might think to yourself, “Well, I wouldn’t go back to spending. No, not me.” If you thought that and truly meant it, you’re in the minority in the United States right now. Most people who find themselves on a continuous cycle of overspending either are continually rescued from their mistakes (and thus they continue to make the same ones), reach a financial meltdown, or gradually wake up and smell the roses on their own. For me, it took a meltdown.

For me, financial responsibility is like a light switch. It’s either on or off, and it takes a lot of work to move the switch from off to on – that’s what this site is really about. It takes a lot of thinking, reflection, and guidance for most people to make the switch.

How you handle a windfall depends entirely on where that light switch is for you. If that switch is not turned on quite yet (and if you’re racking up credit card bills or hammering a home equity loan, it’s not), then putting a windfall into debt repayment does little more than facilitate more spending on things you don’t need. Instead, you’re much better off buying things that will give you some more breathing room for the long run, particularly things you can’t immediately tap, like a Roth IRA, energy use reduction through CFLs and programmable thermostats, or a home improvement project. Paying off debt, if you’re not committed to truly eliminating the debt, is no different than just directly spending the money on frivolous things.

Isn’t paying off debt the best way to get “bang for the buck” from a windfall? In some cases, it is, depending on the interest rate on the debt. However, if paying off the debt does little more than “free up the credit card” for other stuff, then it’s a very poor way to use a windfall. That’s why, in most cases, I advocate using that money to ensure a better financial position unless you’re truly committed to reducing your spending.

In short, a windfall doesn’t help that much if you’re continually spending more than you earn, because in the long run you’ll just wind up back where you started. Thus, by putting windfall money in a place where you can’t easily spend it, you’re ensuring that the windfall produces value for you for years to come.

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  1. Rick says:

    I agree with you that the answer to this question is primarily related to you attitude about finances. In contrast to your example though, I have a friend who received an unexpected inheritance, and used it to pay off some large student loans. I think in this case this was her best choice. She does not spend frivously; she simply had a lot of debts from attending school, so she used this windfall to become debt free.

    That being said, if *I* received an unexpected windfall, I would invest it. I could most likely achieve a higher rate of return from the stock market than I could from paying off my few debts, since they are all fairly low interest, and my student loan interest is tax deductible anyway.

    Again, I think it simply depends on your attitudes about debt and your finances. If you can’t control your spending, you may need to “protect yourself” from your windfall. But if you’re financially savvy, then do whatever achieves you the highest rate of return.

  2. briana says:

    We have had a series of windfalls this year (bonuses, raises) that we’ve applied to debt. I really do think that it was the best choice for us, because our three-year goal is to eliminate our consumer debt. Seeing that we’ve already paid off several cards gives us motivation to keep plugging away with the monthy payments. Also, once a card is at zero, we feel motivated to keep it at zero. Once you start forgiving yourself for carrying a balance, it becomes easier to justify spending on things you can’t afford.

    We are still using our cards occasionally, but only when cash is not an option or under specific circumstances (with one particular card we get bonus airmiles when we pay using it). We now track every dollar that goes on the card, and we pay it off every month. No more ‘someday’ repayment plans.

    We did, however, split the windfall money between savings and debt repayment, so that ’emergencies’ and big expenses are no longer paid for on credit. We’re well on our way now with both the emergency fund and our debt repayment.

    I see a lot of parallels between overspending and other addictions. For one thing, unless your attitude about it has genuinely changed, attempts to quit problem behaviour are likely to be short-term. A change in outlook, however, is a strong enough motivator for long-term change. Whether you’re quitting smoking, cutting ‘bad’ foods out of your diet, or getting your finances under control, you will keep relapsing into old habits unless there has been deeper change within.

  3. Shane says:

    This is a really good way to look at this. I was thinking what Rick said. You only pay down the debt if the interest on it is greater than the interest or return you can get by investing the money.

    That said, when people find a spark of good luck and use it to pay off the debts from bad spending habits, chances are they’ll be right back where they started very quickly.

    It’s better to consciously do the hard work and change your spending habits.

  4. martha in mobile says:

    Some financial advisers recommend, upon receipt of a windfall, purchasing a small treat (so you don’t feel deprived) and then locking the money up so you can get used to having it. It seems strange (probably especially so to the financially savvy folks on this site) that having more money than usual can make some people uncomfortable and they will get rid of it (i.e., spend it) as quickly as possible. This technique has worked for me over the years.

  5. rhbee says:

    Spending like eating appears to be a need that can get way out of control. One time I was in a dieting program and had reached a plateau. I couldn’t lose couldn’t gain. Then I got sick, in one day of fever and sweat I dropped 12 lbs. Wow, what a windfall. The only problem was that I then dropped out of the program and within a month I was right back at my pre-program starting weight. Same thing happened when I golden parachuted out of teaching. I had acquired 30K in debt but the parachute gave me enough to pay it off and have six months to start a new and improved life. You guessed it. Six months in and I was 35k in debt and headed to bankruptcy. The external change never reached the internal me. Until I “froze” the cards and stopped eating like I was still a kid at a buffet, nothing changed. And I am still hungry so I have to keep alert to falling back into the same fat rut. But I stopped trying to change the habits of old, I just added a couple of habits that are stronger right now.

  6. Dustin says:

    Hey its me again! I just noticed this on my agregator. Actually, I wasn’t planning on using it for a credit card but rather on student loans. I went to school for a semester, and just had WAY too much on my plate to be able to juggle everything, and I didn’t really know what I wanted to do in college anyways. Now I owe the university money. I figure that paying back something like that is an investment in itself because it would allow me to go back to school when I have decided what I want to do.

  7. Minimum Wage says:

    As a boomer with student loan debt earning minimum wage, you bet I would use a windfall to pay off that debt. Since my earning power is negligible and there’s nothing I want to run out and buy, I’d jump at the opportunity to get out of debt – it’s not as if I am going to earn my way out of debt.

  8. Kevin says:

    Interesting perspective. I don’t see how doing anything else with the money is better than paying down credit card with really high interest. I can see how this would keep her on the same path, but still think the CC should go.

  9. James says:

    In the majority of cases it’s better to invest the windfall than use it to pay down debt. Successful businesses use credit wisely, and always invest excess cash (to increase income). Successful individuals do the same.

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