So you received a big bonus, inherited money, or won a large court settlement. Great! You likely feel excited, but maybe a bit overwhelmed too. You feel pressure to make a good decision on what to do with your newfound money because you want to make the most of it. Where do you start?
First you want to make sure you have an adequate emergency fund. Emergency funds should be anywhere between six months and a year’s worth of living expenses. This rule is purposely flexible; if you work in a field where jobs are scarce, you may want to have an even larger emergency fund. Or, if you have a particularly large expense on the horizon, add that figure to your goal emergency fund. Emergency funds may not be exciting, but remember, life is full of unexpected expenses. Most insurance policies have deductibles — including medical, auto, and home insurance and many disability and long term care policies have waiting periods as well. Do you have enough money to cover these sudden expenses? Your emergency fund will carry you through periods of unanticipated expenses and prevent you from racking up high-interest credit card debt during tough times. Once you feel you have a sufficient emergency fund then you can consider paying off high-interest debt.
High Interest Rate Debt
Review any outstanding loans and determine the interest rate you are paying. Loans that have the highest rates are costing you the most to maintain. Credit cards and student loans might be some of the most expensive, while items like your mortgage – likely your single largest debt — may not be costing you as much, especially if you refinanced or purchased your home in a low interest rate environment. Also, keep in mind that you can deduct mortgage interest from your taxes.
We recommend paying off high interest rate debt first and continuing to pay down low interest loans on your current payment schedule, since you may be able to earn a higher returns in the stock and bond markets than what the debt is costing you to maintain. For example, if your mortgage interest rate is 3% and you expect to invest aggressively, you might expect to earn more in the stock market over long periods of time, thus making better use of your money had you paid off your mortgage in advance. Keep in mind there are no guarantees in the investments markets though.
After building your emergency fund and paying off high-interest debt, you should consider investing your remaining funds in the various markets. First, you need to decide what type of account to open. It helps to consider what you would like to use the funds for in the future. You could use them for retirement, to fund a future purchase, or as a general investment. Those goals might be ten years away, or they could be thirty years down the road. For example, you can open a traditional IRA, Roth IRA, or brokerage account. Generally speaking, traditional IRAs are used for retirement. Roth IRAs can be used for retirement and other goals because you can take your principal investment out without consequence. Brokerage accounts can be used for all goals because there are no restrictions on when you can remove your funds. Consult your financial adviser to determine what is best for you as each account type has different tax features.
Once you have decided what type of account to open, your next step is to determine what stocks, bonds, mutual funds, or exchange traded funds you would like to purchase. Try to match your risk level with your time horizon and risk tolerance. Consider investing conservatively for goals that are short-term and aggressively for goals that are long-term. But always invest where you feel comfortable, don’t take on more risk and fluctuation than you are emotionally ready for. If you are not comfortable with your investment knowledge seek a trusted professional.
Elise Murphy, CFP®