What to do when you win the lottery

…or get your tax refund.

Suddenly you have a ton of money! Yeah! But what do you do with it? You are my wise and clever reader, so you know it is not smart financial planning to blow it all on a sports car. But this new money isn’t in your budget, so how do you fit it into your spending and your goals?

First, you celebrate! It’s exciting, you have a little spare cash! Go buy that jacket you have been dying for. Try that new restaurant. Replace your ratty old gym clothes with something that makes you excited to exercise. Make the celebration reasonable- it should be about 10-20% of your new ca$h money. Spending $500 on a new tv when you got a $1000 tax refund might be going overboard, but maybe getting HBO might be a nice splurge.

Next- look at your debts and your savings goals.

  • Can you pay off a credit card with this cash? Won’t that feel awesome, to not pay interest anymore?
  • Is it enough to make yourself an emergency fund? Then you won’t have to worry about unexpected expenses, and the amount you were saving already towards your emergency fund can go to feed the general pot.
  • Can you invest it in your 401k or your Roth IRA? Earn some crazy compound interest on this free money to make even more free money?!!
  • Should you use it to pay off some student loan debt?

If I were you, I would do a mix of the things above with my newfound cash- but you have to be wise about it (consider your interest rates, my friend). If you can pay all of your debt off- do it! But paying just some of your debt off all in one big chunk may not actually be the best choice.

What if the cash you just received is big for you, but it is just a fraction of your overall debt?

Suppose you are the newly graduated Dr. John Doe. Medical school sure was fun, but the average cost of med school is $170,000. Your monthly payments are almost $2,000. Yikes.

But wait! An unknown- yet extremely wealthy- elderly relative just died peacefully in his sleep. He was so proud of his great-great-nephew the doctor that he left Dr. Doe $20,000.

If Dr. Doe immediately puts that $20,000 into the balance of his student loans, he will now owe $150,000. His monthly payments will be a little over $1,700. Is that much better for Dr. Doe, who may be struggling to make his rent while working those crazy shifts as a resident at his new hospital?

Depending on Dr. Doe’s income, it might be better to save the $20,000 and to use it to make the monthly payments. He can make 10 months worth of payments with the $20,000. The total interest he will pay will be slightly more than if he had paid a lump sum off at once- but not by much (an $8,000 difference). I suspect that early in his career, Dr. Doe would value 10 months of being able to pay his bills worry free more than he will value $8,000 after he is an established doctor.

 

Moral of the story: when you suddenly come into some money, think about your overall financial picture. Paying off part of your debts all at once might not make sense if you are struggling to make monthly payments- but if it lowers them enough to ease some of the burden, then go for it! Look at the parts of your budget that are difficult for you (maybe you just can’t quite squeeze enough cash into your emergency fund) and use the newfound money to help with those areas that are challenging.

Congrats on that lottery win, by the way!

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[James Earl Jones voice] Do You Need Help Paying off Credit Card Debt?

“You want 21% risk free? Pay off your credit cards.”- Andrew Tobias

Did you know, I hate paying for other people to use and manage my money? I hate bank fees, I hate late fees, I hate paying compound interest on my debt.

The all time worst deal on taking out a loan (that is what a credit card is, kids) is the interest rate you pay on credit cards. One of my cards is 17% interest! That means if I have $1000 worth of debt and I only pay off the minimum ($25 a month, on that card) it will take me FIVE YEARS to pay that debt off and it will cost me $1486! I end up paying almost 50% more for everything I bought with my credit card- not savvy at all. You’re paying for designer and you’re wearing TJ Maxx (that you bought five years ago). Don’t do that!

Not only is not paying off your credit cards immediately bad for your closet and your wallet, but you should think about where you want your money to go, as a consumer. You have to buy clothes and food, and you have the option to spend your money on other things. You can buy yourself more shoes, donate to charity, buy organic food, buy video games, save for Lasik, give your money to your sister, pay your college loans off, buy some new wallpaper. That’s awesome- you get to choose where your money goes, and you can invest in yourself, others, or in something you believe in.

If you are spending your money on credit card debt, you are spending your money on supporting credit card companies. Companies that exploit the part of human nature that loves immediate gratification. Yuck. That is not where I would choose to put my money. I’d rather have a new pair of shoes.

Stop a minute. How are you feeling? If you have any credit card debt, you probably feel guilty and annoyed that I am telling you how horrible something that you already hate is. Completely valid feelings. The real way that the economy works is that it takes advantage of  a few flaws in human nature, and it rewards people who can thwart those instincts with their massive brainpower (I’m talking to you, my brilliant reader!)

The reason why credit card debt is so common is because of something called future discounting (sounds fancy, and it sure is! You’re going to learn something new today). Future discounting is human nature. It means that you place less value on $110 that you will get in the future than $100 in your pocket today. You can spend that $100 today, but what is that $110 in the future gonna get you?  You will probably have way more money in the future, and maybe that $110 will not buy as much because of inflation, so you would rather have $100 right now. This is how credit cards work. Foiled by our own future discounting!

How do you overcome this teeny flaw in human nature to become the master of your own destiny?  Here is the strategy:

1. Stop charging more than you can afford. Look at your budget. Is what you are charging in the budget? Will you have enough in your checking account to cover this purchase? No? Then don’t buy it. Check out my tips to slenderize your spending.
2. Pay off more than the minimum amount due and set up automatic bill pay so you don’t tempt yourself to just pay the minimum when you pay your bills. If I made $50 payments instead of $25 payments on my TJ Maxx debt, I would pay off my debt in two years and it would only cost me $1184 total- you can save $302 just by paying a little more off each month! Stopping compound debt in its tracks feels just as good as earning compound interest.
3. Think about interest rates. If you are investing $50 a month and earning 6% and you are paying off debt that is costing you 17%, you should be putting that $50 investment money towards your debt. You will save more money on paying off debt interest than you would make investing. If you have any wiggle room in  your budget and if you are putting money into long term savings, I recommend that you shift that money over to debt reduction (provided the interest rate on your debt is higher than the interest rate on your savings).

If you have more than one credit card, pay off the card with the highest interest rate first. Some schools of thought say that you should pay off the smallest amount first so you have a victory under your belt and you stay motivated- that is fine too, but it will cost you more (but spending money to stay motivated is a legitimate expense so if it works for you, go for it!)
4. If you haven’t maxed out your credit cards and you still have access to some funds in a pinch, it is better to wait before building an emergency fund. If an emergency does happen before you have an emergency fund, you will probably put the expense on your credit card where you will be charged interest- but only if an emergency happens. If you build an emergency fund while paying off your debt, you will definitely pay that interest on your debt. Go with the option where you MIGHT pay interest rather than the option where you WILL pay interest.
5. Call your credit card companies. See if they can lower your interest rates, and while you’re at it, see if they can stop charging you any stinkin’ fees you might be paying. They work for you, and if they won’t help you can always tell them you are thinking about closing their credit card- they hate losing customers.
6. If you are still drowning, think about consolidating your credit card debt. To do this, you can transfer your debt over to a card with zero interest for a certain amount of time. There are a few pitfalls, because opening more credit cards is not necessarily good for your credit. If you choose to do this look for the lowest interest rate. That being said, don’t charge more just because you have an amazing (or no!) interest rate for a certain period of time. It will bite you in the butt and then you will have to start over at step 1.
7. Make a plan and stick to it! If you have promised yourself to pay off your newly consolidated debts, that should be your main financial goal. If you are having a hard time laying off the plastic, switch to a cash-only budget. I just read a study that found that spending is reduced by 20% on average when you use cash instead of credit cards.

You might be finding this completely intimidating. You might feel like it is hopeless and you will be mired in debt forever. YOU WILL BE FINE. Just like saving up for Lasik, eliminating your debt is a slow process. Cut back on your spending, automate your bill payments, and relax about it for now. You have a plan, you are following the plan- and you are right on track. So pay attention to your debt, but stop worrying about it. Check back in in 3-4 months. See how your progress is. Readjust if you need to. When you make a plan for yourself and you follow that plan, you are making the best financial decision that you can make. Instead of worrying about unknown debt you can now say with confidence that you are in control of your finances and there is no need to worry about the unknown. Do you feel better? Me too.

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