How To Pay Off Debt With a Lump Sum

by · 6 comments

The question:

DFA reader Denise asked:

My husband will be getting a lump sum next week of about 110 k. This is a settlement from a workers comp case. It will change a lot of things for us. For one. We will be able to pay off almost all debt (mostly medical bills) and another is our monthly income will be reduced by $860 a month. Yikes! We also have a car loan with about 15k left and my student loan which is in collections and is being garnished from my paycheck each week. not much I can do about that. Another 30k plus to go!

My question is basically what is the best way to go about paying off the car loan which is financed at over 20%, to make the most positive impact on our credit report? Ideally we would love to do it within six months.

The answer:

Thanks for your question Denise.

As I see it you have several options:

  1. pay off the car in one lump sum
  2. bank the money and continue making regular payments until the car is paid off
  3. start paying your student loans.

Let’s take a closer look to see what works best for your situation.

Lump sum aka windfall

How to pay off debt with a windfall

Today the term windfall refers to a piece of unexpected good fortune, typically one that involves receiving a large amount of money, but originates from an apple or other fruit being blown down from a tree or bush by the wind.

Windfall’s can be – and should be used as – great kickstarts for getting out of debt!

Your credit score

You mentioned your credit score which shows you are concerned about how to make it higher.

I have my own opinion about credit scores, but we’ll set that aside for now to best answer your question. (Use this credit score resource to help find or improve your score.)

The best way to improve your credit score will be to get your student loans current and out of collections. Use the combined resource of your monetary lump sum and the flexibility of repayment offered by your student loan guarantor. (Use this student loan resource to find your best solution.)

Your auto loan

Since you’re paying around 20% interest on your auto loan you want to get that paid of as soon as possible.

To give you a better idea of how much this loan is costing you let’s take a look at an example amount being financed at 20%.

According to BankRate.com’s auto loan calculator, a 4-year $15,000 loan at 20% means a $450/month car payment with $250 of that going toward interest. At the end of this loan you will have paid nearly $7,000 in interest!

That is unacceptable, so pay it off as soon as possible.

Conclusion

If it were me I would use the lump sum in this order:

  1. pay off the medical bills
  2. get the student loans current
  3. use the rest to pay off (or down) the auto loan.

Once you have the auto loan paid down (or paid off) you can set up automatic payments to your student loan guarantor so you no longer have to worry about late payments, collections, and wage garnishment.

Note: although it may not apply to this situation, others reading will also want to consider investing some of the lump sum. I usually recommend passive investing strategies.

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photo by Steenbergs



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1 Denise

Thank you for answering my question. I think I left out a very important piece of information though in my question. That is, we are using the majority of the lump sum to put a down payment on a house, hopefully within a year, which is why I am so concerned about our credit scores. Taking the student loan out of collections (CAN I DO THAT IF ITS BEING GARNISHED FROM MY CHECK EACH WEEK AND FROM MY TAX REFUND EACH YEAR?) and paying that off would take away that down payment on a house. Here on Long Island everything is super expnsive so I am anticipating at least $40k down. All debt is now completely gone (although some still appears as bad debt on out credit reports) except for my student loans. So basically, I was asking if it is better to pay the car in a lump sum, or is it better to pay, say for the next 6 months, until it’s paid off? I don’t know if lenders would rather see the steadier payments rather than all at once. That’s what I meant by which would have a more positive impact on our credit score.

2 Joe Morgan

Are you sure you can afford the house with everything else going on AND a reduction in income?

3 Matt Jabs

Paying it off in a lump sum or over 6 months will make little difference in your credit score. What will make the biggest difference would be to get the student loans out of collections. Call your student loan guarantor and talk it through with them. I would recommend avoiding a home purchase in the midst of all this. Rent instead and continue to save money until your financial situation is healthier.

4 Suzan

In my opinion, getting your student loans out of collections should be your first priority. As Matt said, that will improve your credit score greatly, plus you won’t have anymore garnishment once they are paid off. Medical debt isn’t reflected on your credit score unless they are turned over to collections. Thus, I would do that last, after paying off your car. Take the steps to pay off the student loan debt, medical debt and car loan debt before you get a house. Live within your means and rent, as Matt said.

5 Denise

Thanks all. The car has been paid off, in addition we bought a Town and Country outright, got the student loans out of collections with a 12k deposit and it is now under control. We have zero debt aside from the student loan and have plenty left in savings, including a down payment for a house which we will look into in 2013. All is well. Denise

6 Matt Jabs

Great to hear Denise, nice work!

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