Is Paying Off Debt With a Windfall a Good Idea?

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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