You got a big bonus at work, and after celebrating, you’re wondering what to do with it. There are many bills — not the least of which is a car loan you’ve desperately wanted to pay off.
Putting most of your bonus towards the car loan makes sense, but you’ve also wanted to beef up your emergency fund and add more to your retirement accounts.
What’s the best use of your money, and when would it make sense to pay off a debt rather than use it for savings?
One of the main reasons paying off debt with a windfall makes the most sense is if you need immediate financial relief. It could be that you’ve been struggling to make the monthly payments, or freeing up your budget can give you the breathing room you need.
Being behind on your bills could negatively affect your credit score. Credit behavior is a primary factor in how scoring models calculate your score. You could see a boost in your credit score by using your windfall to pay off a credit card balance or to catch up with your loan payments.
A high credit score offers other benefits. It makes getting approved for loans or credit cards at competitive rates easier.
Even if you can afford your monthly debt payments, paying off debt early will save you money. Providing you aren’t subject to a prepayment penalty, you could save thousands of dollars or more in interest depending on your loan terms. You could then direct the money saved on interest towards other financial goals, such as investing.
Prioritizing paying down high-interest loans also gives you a better chance of getting a better return on your money.
For example, say you invest the money instead, and on average, your investment returns are around 7%. If your car loan is 12%, you would be better off paying down the loan before you invest, as your investment returns are not likely to exceed your loan interest rate over time.
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Investing first could make more sense if you have very low-interest debt. While investment returns aren’t guaranteed, the S&P 500 index, which represents the 500 largest companies listed on stock exchanges in the U.S., has delivered average returns of around 10% before accounting for inflation.
