This article explains how money received out of turn – bonus, arrears, etc – should be utilized prudently to improve your financial health.
From time to time, we get lump-sum money which is largely unexpected. For example, this can be a yearly bonus – which many of us would be receiving around this time of the year.
Another very recent example is that of government and public sector employees – with the implementation of the sixth pay commission, most government employees would receive a very handsome hike in their pays. And since this hike is to be effective from 1st January 2006, they would also get arrears – which is a lump-sum, unexpected amount.
What to do with this money?
This kind of windfall money – relatively unexpected – is something for which we would not have any plans. This means that most of us don’t know what to do with it!
The sad result is that most people end up spending it on big ticket purchases – like laptops, cars, jewellery or LCD TVs. But is this the right way to spend it?
The fact that we don’t have any pre-decided plans for such windfalls (for example, you would not be banking on your arrears to buy a car!) means we can be really flexible about how we spend it. And this means we can deploy it more wisely if we give enough thought to it!
So, how should you deploy this windfall? Here’s how…
Debt, or loan, is something on which you are paying interest. This means that you are not just returning the amount that you borrowed, but are paying extra money for that facility.
So, when you have surplus money, the very first thing to do is to repay debts.
Which loans should be repaid first? Obviously, the loan with the highest interest rate!
Undoubtedly, credit cards charge the highest interest rate among all financial products (in the range of 30-40% per year). Therefore, your very first priority should be to retire the high-cost debt on your credit cards. This means paying all your credit card bills in full, and not just the minimum amount due.
After you have paid all your credit card bills in full, the next in line would be any personal loan that you have. Personal loans cost around 16-18% a year, and therefore, are high cost too. So, repay whatever you can! Even if there is a prepayment penalty (usually around 1.5-2%), it is worth repaying this loan.
Next would be a car loan. These cost 12-15% per annum, and should also be prepaid if you have surplus money.
Another loan that most of us have is a home loan. Should you prepay your home loan? My advice would be against prepayment of a housing loan – the main reason being the favourable tax treatment that home loans get. Please read “Income Tax (IT) Benefits of a Home Loan / Housing Loan / Mortgage” for more on this.
There are lots of other factors too while considering prepayment of a home loan – please read “Should you prepay your home loan?” for more details.
Once you have repaid your high cost debts, invest the remaining amount wisely.
All of us need to have a contingency fund – a fund that is sufficient to take care of our day-to-day expenses for a couple of months. This is the money that you would bank on in case of medical emergencies or in case of a job loss.
This fund should usually be equal to your 3 months income. Saving money equal to your 3 months income can take a long time in the normal course. But if you receive a large lump-sum amount, you can easily create a contingency fund!
Invest the money for such a fund in avenues that are fairly liquid – for example, bank fixed deposit (which can be broken if needed). Better still, it can be invested in a flexi-account that most banks offer these days – surplus money from your savings account is automatically invested in FDs, and you can withdraw these funds any time without incurring any penal charge!
A lump-sum amount can also be a very good opportunity to work on your goals and prepare a game plan for reaching your goals. If you already have your goals defined, and are working towards them, the amount can be invested in a long term goal, which would reduce your regular monthly investment needs! Please read “Goal Based Investing” to know more about this.
This money can also be invested in equities if you want to invest for a long term. Equity investments can give tremendous returns in the long term, and this is an option worthy of your consideration.
Considering the fact that stock markets have corrected significantly in recent time, this is an excellent time to invest in stocks. So, why not?
If you decide to invest in equities, another issue that you would face is: Should you invest directly in individual stocks on your own, or should you invest using Mutual Funds (MFs)?
Well, for new investors, investment through diversified mutual funds having good track record is the best option. I would recommend investment through mutual funds for most readers. If you want a detailed comparison between direct stock investment and investment through a mutual fund, please read “Direct investment in Stocks versus Mutual Funds (MFs)?”
With sixth pay commission implementation, and with the yearly increments around the corner, most of us would see our income increase significantly. This means we would have more money to spare every month.
Isn’t it a good opportunity to look at our insurance coverage, and enhance it if it is not adequate? (To know how much life insurance you need, please read “How much is your life worth?“)
If you feel you don’t have enough life insurance, increase your cover. Do it using term plans, and don’t get tempted to buy costly insurance in the form of a Unit Linked Insurance Plan (ULIP) or an Endowment Plan.
Term plans are the best when it come to insuring your life – they cost the least, and provide just what is needed – life cover! Please read “Term policy is the best policy” to learn more about the advantages of term insurance.
Also review your health insurance cover, and buy more if needed.
The bottom-line: Utilize your windfall efficiently, and reap long-term benefits.