Is it smart to use most of your work bonus to pay off your debt? Here are the pros and cons of repaying loans with a windfall

When to pay off debt with extra cash

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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When it makes sense to invest or save instead

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.

If you’re only paying 4% or 5% on a car loan, it might make more sense to invest your windfall and continue making the loan payments.

And don’t forget about short-term savings. An ample emergency fund, for example, could give you a buffer to cover unexpected medical bills, car repairs or a leaky roof, helping you avoid taking on more debt to pay these expenses.

Of course, you could use your windfall for several financial goals at once. For example, you could put 50% towards your car loan, 25% towards an emergency fund, and the remainder into investments.

Ultimately, you’ll want to consider the opportunity-cost of whatever financial decision you make, whether you’re prioritizing debt or investing and saving.