Receiving a lump sum of money is awesome, but for people seeking Financial Freedom deciding the best thing to do with that windfall can be challenging.
Whether it’s an unexpected sum, such as an inheritance, or something planned, like a work bonus, tax refund or proceeds from the sale of a property or vehicle, identifying the best place to put that money can leave a lot of people with analysis paralysis.
Like all things finance, there is no one size fits all answer, and at the end of the day the best answer depends on the totality of your financial situation, but here’s a few suggestions that will apply to the vast majority of situations.
1) Pay Down Debt
So obvious, yet it’s the choice people make the LEAST often. Investing your money is great, but if you carry outstanding debt, the money you will save on the interest you are paying on that debt is a guaranteed return. And at the end of the day, every source of debt you carry is just another lock on the chain that binds you to your job.
This is absolutely the best option if you carry any type of credit card or high interest debt. You won’t even come close to making as high of a guaranteed return investing your money anywhere else.
If you don’t have high interest debt, paying off your debt is still a good option. Despite the fact that interest rates continue to sit at all time lows, it certainly isn’t going to stay that way forever, so make hay while the sun shines and pay back the money while it is still cheap to borrow.
So what debt do you pay off first? Well, if you have multiple sources of debt, the rule of thumb is to pay off the source with the highest interest first. Which is an excellent approach if you are a either a computer, or an extremely logical person who can implement a long term payment strategy with no emotional investment.
But what that rule doesn’t take into account is the psychological factor and benefit of eliminating a source of debt completely. Wiping out an entire debt source can be hugely motivating, and help keep you focused on your overall debt repayment plan. It can also reduce stress by removing one mandatory monthly payment, giving you a little extra breathing room.
This also gives you the option to reallocate that monthly payment to other debt sources, and pay them off even faster.
If the choice is between paying off a credit card at a 20% rate, or paying down your mortgage at a 3% rate, the decision is a no brainer. But if you carry debt on several credit cards with varying rates, you may be better served to eliminate two or three of the smaller credit card debts at slightly lower rates, rather than paying down a only portion of a larger one, even if it has a slightly higher rate.
So take a look at all your debt sources, is there one or two that your new windfall could completely eliminate? Consider paying those off, and immediately re-allocating any monthly payments from those debts to your other debt sources.
2) Build Your Emergency Reserve
Some people will argue that having cash on hand is cash that is wasted and being devalued each day. I won’t argue that some opportunity is lost by not investing it, but having an emergency fund that can cover off at least several months of expenses is peace of mind and security when life takes an unexpected turn. Frankly, I think that’s worth whatever return you might get had you invested those funds.
I don’t recommend saving an emergency fund if you have debts other than your mortgage and perhaps your vehicle still outstanding (depending on the interest rate of your vehicle). The benefit of paying off shorter term, higher interest debts still outweighs building your security fund, but once you’ve eliminated those debts, an emergency fund should be your next priority.
3 months of expenses is the industry recommended standard for an emergency fund, but I would suggest going a little further than that and aiming for at least 6 months. If you get laid off, or become too ill to work, 3 months is not very long to try and replace the lost income, especially under stressful circumstances that may require your attention to be elsewhere.
Having a substantial fund can also give you the freedom to change jobs, pursue an alternative career, or make a geographical move, all with the confidence that you can support yourself (and your family) without going into debt.
3) Diversify Your Investments
If you’ve got your debt well under control, and a substantial emergency fund squirrelled away, then it is probably time to start looking at options for investing your lump sum.
Tax free savings accounts can be an excellent option, and contributing to these accounts (such as RRSP’S in Canada) can have the added benefit of netting you a decent tax return that you could then use to invest in other sources.
But depending on the amount of your lump sum you may also want to consider looking at a real estate investment.
Personally I wouldn’t invest a large lump sum unless I was completely debt free, mortgage included. But that position could be swayed if the investment generated sufficient monthly cash flow which I could then use to make a substantial impact on my outstanding debt. AND I still had a number of years before that outstanding debt could feasibly be paid off.
For example, if I had 7 years left to pay off a remaining mortgage of$250,000, but could invest $30,000 to acquire an investment property that provided me with cash flow over and above its property expenses in the range of $500.00 per month, I would definitely have to give that opportunity a hard look.
The reason being, is that I would have roughly a 5 year ROI on my initial investment (possibly less, because my cash flow could stand to increase with rental prices year over year). And while 5 years is a fairly lengthy ROI, if I took that $500 each month and applied it as an extra payment to my outstanding mortgage, the time remaining on that mortgage would decrease by about 18 months, possibly more depending on the mortgage interest rate. So fast forward those 5 years and now I’m either entirely debt free, or very close to it, AND I own a cash flowing investment property in which I’ve generated substantial equity by paying down the existing mortgage (and maybe it’s even increased in market value). All of which puts me much closer to Financial Freedom than if I had just put the original $30,000 onto my oustanding mortgage.
BUT on the flip side, if I was anywhere near paying off my mortgage, and that $30,000 lump sum paid it off or brought me within a 1 or 2 year striking distance of paying it off entirely, then that is 100% where my money would be going. Once I had it paid off, I would then look to build my investment options.
So before you invest, have a hard look at your time frame for that investment, and forecast what your financial situation is likely to look like at the end of that time frame with the investment versus having simply paid down your debt.
4) Treat Yourself
This one may come as a surprise to many of you, but at the end of the day life is about living, and as much as reaching Financial Freedom is fantastic goal, you still want to enjoy the journey.
So this doesn’t mean go and spend the whole lump sum on a new wardrobe, car, or luxury vacation, but do consider giving yourself leeway to spend a little on something that brings you value. Depending on the amount of the lump sum, maybe that means a nice dinner out, a day at the spa, a weekend getaway, or those new appliances for your kitchen. Keep it reasonable, but so long as you are a disciplined saver/spender, don’t be afraid to reward yourself a little along the way!
In conclusion, approach any windfall from a logical perspective with the hard numbers guiding your way, but don’t ignore the human emotional factors or your own financial personality type when assessing what the best option is for you.