Imagine you just won the lottery (lucky you!). Naturally, the possibilities for what you might like to do with the money are endless. While most people won’t win the lottery in their lifetime, plenty of others might receive other cash windfalls like a huge bonus, a legal settlement, or a large inheritance. Along with all those other exciting possibilities, you might start to wonder whether it’s better to use the unexpected cash for saving or paying off debt.
According to Ted Rossman, an industry analyst on personal finance and credit industries at CreditCards.com, a financial windfall is “a sudden influx of money that has the potential to improve your financial situation significantly.”
A survey by CNBC and Acorns asked how people in the U.S. would spend an unexpected $5,000 bonus. The results found 34% of respondents would use the money to pay off an existing debt, and 22% would save money for short-term expenditures or emergencies. Additionally, 15% said they would invest in long-term goals such as their retirement or college.
What would you do with unexpected cash? We know it can be a tough decision figuring out what’s the best route to go, so to make it easier for you, we asked the experts for their advice on what to do.
First, Address Your Concerns
Elaine Pofeldt, finance editor and writer & author of The Million-Dollar, One-Person Business, said the most important thing to do before touching or deciding what to do with the money is to “make an appointment with your accountant to go over the tax implications of the windfall. Also, talk with your financial adviser – or get one if you don’t have one.”
It’s pretty easy to get excited when you come upon unexpected money, but that unexpected income could also impact your tax bracket, “causing you to owe a lot more in taxes than you ever have before. Make sure you have paid those taxes before you spend any money, use it to pay down debt, etc., or you could end up owing the government a lot of money and wind up worse off,” Pofeldt added.
Kendall Little, personal finance writer at Bankrate, also suggests, talking to an expert before making any big decisions on what to do with the money. “It could have a long-term impact on your finances.”
A survey by Life Happens in January 2019 asked American consumers what their financial concerns are. Answers included retirement savings, long-term care, and medical expenses, monthly bills, credit card debt and emergency savings.
Perhaps you are concerned about these kinds of scenarios yourself, and if you ever find yourself with some unexpected money by yourself, the experts we interviewed have some advice.
Saving Versus Paying Off Debt
When it comes to deciding whether to save or pay off debt, Greg McBride, chief financial analyst at Bankrate says “this isn’t an either-or decision as you can accomplish or work toward both debt repayment and savings simultaneously.” So in the best-case scenario, you will be able to do both when unexpected money comes into the equation.
While there is no clear consensus from talking with experts, takeaways from both perspectives could help you decide which is the best choice for you since this is a pretty individual decision, and has more than one angle.
Those in favor of saving
For Rossman, there is a big question that people should ask themselves: Do I have enough emergency funds saved? But how much is it “enough?” He and many other financial experts recommend a cushion of savings that would cover between 3 to 6 months of expenses.
“That’s going to be a buffer between you and high cost when something goes wrong, your car breaks down or something around the house breaks down. Or even if you lose your job,” Rossman added.
McBride said having a buffer on your emergency funds could also help “with high-interest rate debt the next time unplanned expenses arise.”
Rossman also said each individual needs to think about what their financial stability looks like. “If you have a really stable job, like a government or any union kind of job, your life partner and you both work, then there’s less of a risk.” In this case, you might only need 3 months of expenses saved.
Rossman recommends this money should be accessible in case there are any emergencies or unexpected situations.
“For this money, I would recommend keeping it really liquid, really safe, really accessible. You don’t want this part of your nest egg tied up in stocks and/or your 401K. You should do that stuff too, but that’s going to be separate. Emergency savings should be money that you can touch at a moment’s notice when you need it. So don’t take any investment risk there.”
Pros & cons of saving
Here is a pros and cons list we put together after talking with financial professionals.
|You will have money in case of an emergency, a buffer for unplanned expenses.||You are not going to earn much interest on your savings.|
|It may give you options like being able to quit a job you don’t like.||This money should be used just for emergencies, you should keep it really accessible.|
|It may put you in a position where you can help family members.||There is such a thing as saving too much if you have any other responsibilities.|
|If you have children who are in college or going off to college soon, you may be able to help them pay more of their college tuition if you save money.||If you have high-interest debt, like credit cards, saving more than paying makes you lose money, since you will be paying the interest.|
A vote for paying down the debt
Cory Nichols, an investment adviser and CEO of Yes Life Financial, says that while “paying off debt isn’t sexy, it guarantees a rate of return, in case of credit cards or high-interest rates.”
Kamilah O’Brien, personal financial strategist at Focused Spender, said “The best thing you can do is to calculate your debt and use that cash to pay it off, potentially saving you thousands of dollars in interest.”
On this side, McBride said “it doesn’t make sense to put all the money into a savings account earning 2% if you’re carrying credit card debt at 18%, since 18% [of a] credit card balance is the equivalent of a risk-free 18% return. Prioritize your debt repayment by focusing on the highest interest rate debts first … rather than paying off low-cost debt.”
Kate Crowhurst, a financial literacy educator and director of Money Bites, has a strong preference to “always pay off debt first because of the effect debt has on your mindset. It is a weight that you have to carry around with you because it’s an obligation that holds you back from the freedom of making other choices.”
Crowhurst said paying a debt will be cheap in a moment where you come upon unexpected money, with the interest rates falling on credit. “I would pay off debt so that I could then build up an emergency savings buffer and have more freedom to pursue different opportunities in life, whether that be travel, switching careers or going part-time to spend more time doing what I love.”
Pros and cons of paying off debt
Here is a pros and cons list we put together after talking with financial professionals.
|Paying off high-cost debt is a risk-free return.||There are other ways you could be earning money, like investing.|
|The interest rate you could avoid may be higher than what you’d earn in savings accounts.||The money won’t be as accessible in case of an emergency.|
|If your credit cards are free of debt you can use them for buffer.||You do not have instant gratification like you might with seeing your savings account increase.|
|You’ll have the peace of mind that comes from not owing money.||Paying off debt can feel like spending money on something you already “bought.”|
|You may be able to improve your credit profile, lowering the cost of any credit you may need for purposes such as buying a house.||There‘s no turning back, you can’t ask the lender to send you the money back.|
Wait, There Are More Possibilities
In case you have money saved and your debt situation is in a good place here are some other ideas on how to use the unexpected money that will help you in the long run. While it’s important to balance between paying debts and saving, there are ways to put unexpected cash toward other expenses.
Little said “it’s OK to splurge a little with your windfall. Develop a plan for what you’ll do with the money and incorporate travel or hobby spending into that plan. If you owe debts or need to build your savings, you probably shouldn’t spend it all, but you can set a designated amount aside to spend now.”
So if you have a dream destination or want to make a hobby a business reality, “setting aside some money from a windfall for a splurge like a vacation or a cool new camera makes a lot of sense,” Pofeldt said. “Life isn’t just about the 9-to-5 and paying the bills.”
But if you are thinking more about investing in the future in a longer-term way than conventional savings, McBride suggests investing in a retirement account could help “use your windfall to maximize tax-advantaged retirement savings opportunities. Put the money into a Roth IRA where it can grow without the headwind of taxes, and you can earn higher returns and enjoy decades of compounded growth.”
Also, Rossman suggested doing a hybrid inversion for the future: “Invest, and after that get a home upgrade, add more value to it. Education is also a good way to invest, maybe you want to go back to school, then do it. These are other good ways for future good.”
Charitable causes was also a pretty common suggestion from the professionals that we interviewed. “This may be a once-in-a-lifetime chance to make a significant contribution,” Pofeldt said. And furthermore, charitable donations commonly are tax-deductible, which could be an added benefit.
Now, Should I Save Or Should I Pay Off Debt?
Before making this important decision, think about which option is better for your financial situation.
In words of Pofeldt, “make sure you understand where you stand financially before you make any decisions. Particularly if you have received a lot more money than you are used to having. It’s important to look at your financial life holistically. Many people make mistakes in handling a windfall because they don’t understand all of the moving parts of their financial lives.”
It is normal not to understand all the financial parts in life, since as Pofeldt explains, “Many of us have gotten little education on personal finance growing up. Talking with a personal financial adviser and accountant will help you get the most out of a windfall and don’t burn through it like the lottery winners we often read about.” Keeping, using and investing that money on solutions will give you peace of mind and will have to make money for best for you and your needs.
One last thought from Pofeldt: “Wealthy people don’t wing it. They get expert help.”