Add a windfall to your snowball
September 16th, 2007 | by mbhunter |Windfalls can be either an excuse to spend lots of money or they can be excellent tools for strengthening your financial disposition.
Reducing debt is one of a number of prudent things that can be done with a year-end bonus, yard sale proceeds, or any other one-shot income event. If you have consumer debt, then a good chunk, if not all, of a windfall would be well-placed paying down your debt. Odds are that if you’ve been on a debt reduction plan, the budget constraints have been noticeable. Using most of a windfall is a way to really accelerate the debt reduction process without further constraint on the rest of your budget. Throwing a lump sum at a debt can mean a payoff that is years earlier than it would have been otherwise.
Let’s say that you have a credit card balance of $5,000 at a rate of 19.99% and all you’ve been able to throw at this debt is close to the minimum: $100. Paying $100 toward this debt will mean the debt is paid off after nine years, with an interest expense of about $5,800. (You pay for the items more than twice!) Now, let’s say that this quarter at work was gangbusters and you received a bonus of $1,100, after taxes. If you throw $1,000 at the credit card (and go out to a really nice restaurant with the other $100), and pay off the remainder of the debt as you would have without the bonus (in $100 payments) then the payoff time will be about 5 1/2 years, and the interest expense will be cut by more than half, to about $2,700.
Why such a big difference? Amortized loans (which is essentially what credit card debt is if you don’t add to the debt and make identical payments each month) is front-loaded on the interest. So knocking off a big chunk of the principal at the start cuts out a lot of future payments because all future payments will be more principal and less interest than they would have been without the windfall payment.
It’s encouraging to watch a loan balance go down faster. Throwing windfalls at those loans can jump-start that encouragement.
