Add a windfall to your snowball

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.