What should I do with a financial windfall?” is a question I am often asked. As in, “I just got my government stimulus check.” Or maybe, “I got a raise at work so I have more income, what is the best use of the extra money?” Or perhaps, “I inherited some money from my grandmother what should I do?”
Generally, these questions involve two options: 1) paying off debt –either credit card or educational debt; 2) investing the money. There is a third option of spending the money now but usually no one asks if that is a good idea. They just do it because they have already decided to spend the money usually before they even have it.
Someone sent me a link to an article about this topic that posed the question to Warren Buffett. None of us have Warren Buffett’s bank balance or net worth. However, there is much to learn from a quick read of the article and some of his life style examples. See the link below for the article. (1) Now on to the questions.
If you find yourself with some excess cash and at the same time are burdened with some “expensive” debt, by all means pay off the debt. Expensive debt includes both credit card and education debt that you pay in excess of roughly 8%. You may want to Get rid of that stuff! Then ask yourself, how did you come to have that debt? And why do you still have it? Then the hard question. If you pay it off, will your balance stay at zero? Or will you merely create new debt?
Sometimes the car breaks down or the plumbing is leaking and the only way to pay the bill is use a credit card because you have no money in the bank. And because your paycheck is only enough for food, utilities, and rent / mortgage there is no extra to pay off the credit care balance so you pay the card’s monthly minimum. Then it happens again, so the balance gets bigger.
Or maybe you “have to have a vacation” that requires airfare, hotel and new wardrobe and you whip out the card and that adds to the previous balance, etc, etc. I think we all know how this goes on and on. Easy solution…..that is hard to do.
Pay off the card if your financial situation allows, do not allow a balance….any balance to reappear if you can.
Second situation, you have a pay raise and more cash flow. What to do with it? If you have expensive debt over 8%, pay it off as soon as possible if you can. But should you save the money or use the extra to pay extra on your mortgage?
That is a more challenging question. I will reference Warren Buffet’s question in the article. Can you earn more on your invested money that the mortgage costs you?
Stop. Stop. Stop. I need to back up. Do you have a back-up, cash reserve, money in the bank to pay for the next round of car repairs, plumber or roof leak? What if you lose your job, what will you live on until you get a new one? Create the personal financial safety net first. Then talk about investing verses paying off the mortgage.
This is what your financial plan is about. What are your money priorities? There are only a few financial things you may have any real control over: 1) how much you spend; 2) how much you save; 3) how long you work. Please note, I did not say how much money you make. Believe it or not, lifetime earnings, an inheritance, or even winning the lottery has little to do with financial well-being, success, and certainly not happiness.
I believe that Warren Buffet would have been well off financially without Berkshire Hathaway. Why? He is a saver and above all he was as my dad would say, not ‘spendy.’ It is reported that Warren still lives in the house he and wife bought in the 60s. Granted, now he has a second home in Laguna Beach – see the article – that he bought with a mortgage long after he could afford two or three or ten beach-front homes.
Sorry, I digress. Back to the financial plan. Assume you know how long it is you want to work. You have a target date to stop working for money. Now, how much will you be spending at that time? What will your needs be for items like food; utilities; health care; mortgage (if you have one); contingency fund for the broken car, roof, water heater, etc? How much other money do you “want” to spend for things like trips, motor home, new car, remodeling the house? Then what is on the wish list like the Corvette, vacation home, paying for the grandkid’s college?
Then a couple of hard questions without “knowable” answers. How long will you be retired? Or put another way, how long will you live? Then what will inflation be during the twenty or thirty or forty years of your retirement?
Now that you know all of these numbers, you can, perhaps with the assistance of a financial planner, do the math. How big a pile of money will you need? Remember, only two things make money: 1) a person at work for pay; or 2) money at work. If you stop working for pay, then you need money working for you. How big a pile of money will you need to support you for the rest of your life--- assuming you live longer than you expect….and the last few years of life are very expensive? The answer is dependent on how much money will your money make for you.
Wow, all you wanted to know was what should you do with this extra money. Be careful of what you ask for? You may learn more than you wanted to know. Short answer, if you can pay off the credit cards, work hard on getting rid the educational debt, and build of an emergency fun. Then consider creating a net worth. If your investments are earning more than the mortgage interest rate, consider adding to the investments and not accelerating the mortgage payments.
Your net worth is your assets reduced by your debt. Savings, investments, 401(k) are all investments. Your home, while part of your net worth, is not an investment unless you have a plan to somehow access and spend the equity. While not having a mortgage payment reduces your living expenses, the equity provides you no cash flow or spendable income. The equity won’t buy groceries, pay for a trip, a new car, health care, or to remodel the bathrooms. One way to tap into the equity is to sell the house or consider a HECM (reverse mortgage)if you financial and living situation permits.
If you want / wish to pay off your mortgage, it should be part of the financial plan. We have many discussions with clients in our Escondido office or on ZOOM calls around San Diego and beyond about the pros and cons of all aspects of their financial plan. Call or email us with your questions. If you know someone without a financial plan, please consider forwarding this blog to them.
The views and opinions expressed are those of the author, and the information should not be construed as individual investment advice, or as the opinion(s) of Voya Financial Advisors.