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How Not to Blow a Financial Windfall

The Wall Street Journal recently published a story about two people who were awarded substantial financial settlements for injuries and hardships, only to lose it all not long afterward.

In each case, the person had sacrificed a good portion of his structured settlement — recompense that’s typically designed to be paid over time — to lenders that specialize in converting streams of future payments into upfront money. It’s a process known as “factoring” or, in even wonkier terms, discounting future payments to the present value.

Take, for example, the lottery.

You’ve won an entire $200 million jackpot. If you elect to be paid the money over the standard period (20 or more years), you can expect to realize every nickel of your prize, minus its tax. But if you choose to receive one lump-sum payout, that jackpot could dwindle in value by 20% to 30% or more.

The concept behind that difference is the “time value of money,” where a dollar in hand today is worth more than that same dollar a year from now, when inflation (or the rate of return on a competing investment) is taken into effect.

When a structured settlement is financed, payments that in the normal course would flow over time to the recipient are transformed into a smaller lump sum today. Similar products to structured settlements include payday, bill-pay and account-advance loans for consumers, and merchant-advance loans for small businesses.

The rate at which those future payments are discounted to their present-day equivalent, however, isn’t the only concern. There’s also the matter of how that hefty payout is managed; in each of the Journal’s profiled cases, the remaining cash that was intended to support the recipient and his family over a long period ended up being squandered.

Planning for the Windfall

If you’re counting on a financial windfall to help make ends meet in the future, resist the temptation to speed things up and let the cash flow as it was intended. But whether you take everything upfront or during a longer course, devise a plan for managing the money so that it will last.

Understanding the Cost

No financial institution will pay you now the same sum it has agreed to pay later. At issue is the rate of interest the payer (the lender, in this instance) proposes to charge to convert your future receipt into present-day currency. So consider this rule of thumb: When the cash isn’t truly, urgently needed and the discount rate is greater than what you can reasonably and reliably expect to earn over time, say no to the quick deal. However, if you really need that cash now, hang tough and negotiate for the lowest APR (the mathematical combination of interest rates and fees) that you can get. Remember: the lower the rate, the higher the upfront payment.

Know What You’re Signing

Many states have already legislated or are contemplating new consumer protection laws for structured settlements and other forms of cash-flow-accelerating financing products. In any case, make sure you understand the terms, conditions and costs of the deal you’re thinking of signing before you reach for that check.

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This article originally appeared on Credit.com.

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