What to Do With Unexpected Money?

what to do with unexpected moneyIt can happen in everyone’s life that we receive an unexpected, larger amount of money. This can be due to various reasons, like heritage, bonus from your employer, or a lucky weekend in Las Vegas. Many people would simply spend all, or most of such money. You can buy a fancy new car, a badass home movie system or go on an exotic holiday. Easy come, easy go, right? But investing it, or doing something other, financially reasonable thing with it might be a slightly smarter decision. In this article we will check what you can do with the money that has just fallen into your lap.

Paying Off Debt

Investing might be the first thing coming to your mind, but first you should have a look at your debt situation. Typically you can have the followings:

Credit Card Debt

debt

This is something you should immediately eliminate. Interests on credit cards are typically double digits in percentage. There is no safe way of investment that you can beat it. If you have any credit card debt, the first thing you should do with the money is paying it off.

Car Loan

The interests on car loans are much less than on credit cards, but they are typically still higher than any type of (relatively) safe investment returns. Because of this reasons car loans should also be paid off.

Student Loan

Depending on which country you live in, student loan can be a significant burden. Even though there are companies out there with whom you might be able to restructure your student loan debts with more favourable conditions (especially in the current low interest rate environment), it would still be a wise idea to pay off your student loan as well. You will be very happy with the extra cash that you won’t need to pay against this each month in the future.

Mortgage

This is something very tricky and you should have a look carefully your current mortgage situation. First of all there are cases when it definitely worth paying off all, or at least part of your mortgage. In other cases the math might show that you would be better off with investing. This is a long ongoing debate and the topic itself deserves a separate article. No matter what the numbers will show after doing the math, in either case I believe it is wise to keep your outstanding mortgage at least 70-80% below the current value of your property.

Also if you believe that in the future you might have problems with mortgage payments, you should seriously consider paying the money against your mortgage, instead of investing in something that you might be forced to sell with a loss due to emergency.

Investing

Investing

Now that you considered your debt situation, you can think about investment. There is a constant debate on which is better: investing the amount at once or over time.

Based on a study made by Vanguard, historically lump sum investment has slightly over performed dollar cost averaging. However, the difference between the results of the two methods is not that significant (an average of 2.39%).

This is not a big surprise: stocks and bonds historically produce higher returns than holding cash.

There is one reason why investing over time might work better for some people, and this is human nature. Even though emotions should be put aside when it comes to investing, people tend to panic in case of losses. In such cases unreasonable decisions might turn unrealized losses into realized ones. Also, a possible drop in stock prices allows you to purchase at cheaper prices in case you have some cash reserves. Needless to say it also works the other way around…

In case you chose dollar cost averaging and spread your investments over a 1-2 years period, you might still want to consider holding some safe, investment grade, short term bonds instead of 100% cash. Here is an example with EUR 400,000 unexpected money:

  • Year 1, quarter 1: Invest EUR 50,000 and buy short term bonds for EUR 200,000. Remaining cash is EUR 150,000
  • Year 1, quarter 2: Invest EUR 50,000. Remaining cash is EUR 100,000
  • Year 1, quarter 3: Invest EUR 50,000. Remaining cash is EUR 50,000
  • Year 1, quarter 4: Invest EUR 50,000. No more cash.
  • Year 2, quarter 1: Sell ¼ of the short term bonds (value should slightly exceed EUR 50,000) and invest
  • Year 2, quarter 2: Sell 1/3 of the remaining bonds and invest
  • Year 2, quarter 3: Sell half of the remaining bonds and invest
  • Year 2, quarter 4: Sell the remaining bonds and invest

How and what should you invest in is a totally separate topic and it depends a lot on your personal situation. You might want to check out the following related posts in this matter:

Summary

I hope the above thoughts helped you to get a clearer picture on what you should do with your unexpected income. I’m personally not a big fan of the “easy come, easy go” mentality and believe that every amount (no matter how big or small it is) you invest in your future is something you will be thankful for in a couple of years.

Readers, have you ever received unexpected money for any reason? If yes, what did you do with it? Do you have any recommendation for those who are in this situation? Please share your thoughts in the comment section.

 

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Disclaimer: This post or any other information on the site is not intended to be and does not constitute financial advice or any other advice. I am solely sharing my idea, plan and progress on financial independence and early retirement.

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