I occasionally get this question – especially around the time of tax refunds. When someone comes up with an extra $1,000, they often want to know how to best use that money wisely to help out their overall financial condition.
Of course this question has different answers for different situations. I’ll run through several different sets of conditions that a person might find him or herself in, and some suggestions for how you might use an extra $1,000 to best improve your financial standing. (It’s important to note that you don’t have to have an extra $1,000 lying around to use this advice – you could have an extra ten or twenty or fifty bucks a week and put it to work with the same principles.) The point is to find money that isn’t being spent on something critical, and put it to work for you! Even small steps amount to wonders.
If you have consumer debt, including credit card debt, auto loans, student loans and the like, it makes the most sense to use this money to bring down your overall debt balance or eliminate it if you can.
If the interest rate on your debt is greater than about 3% or 4%, you aren’t likely to find a better way to invest an extra $1,000 than to eliminate some of your interest costs. This is because debt is a negative investment – when you have debt that carries an interest rate of 8%, year over year while the debt balance is there, you are “earning” a –8% return on that money.
Some folks recommend eliminating all debt, but that’s a bit impractical in today’s world. Low-cost mortgage debt and auto loans can be good uses of leverage – especially mortgage debt at the rates we’ve seen of late. I suggest that you focus on the highest rate consumer debt first and foremost, eliminating this drag on your financial state. Once you’ve eliminated every debt except for mortgage debt, you can move on to other pursuits. Eliminating consumer debt at high interest rates is the best move you can make to improve your financial self.
An emergency fund is an amount of money set aside that can be used to cover all of the unexpected expenses that come up and surprise you: new tires for the car, roof replacement, or medical expenses not covered by insurance, for example. The other thing that an emergency fund is for is to give you some “cushion” if you find yourself unemployed for an extended period of time. It’s for this reason that an emergency fund is typically referred to as a certain number of months’ worth of expenses – such as 3-6 months’ worth of expenses. You should have an emergency fund of an amount that would provide for your living expenses for several months should you be unexpectedly laid off.
If you don’t have an emergency fund, or if your emergency fund is smaller than you should have set aside, this is another great place to put an extra $1,000. Typically an emergency fund is in a place that’s a bit difficult to get at – such as a bank savings account without debit card or ATM access. This way you’re not tempted to invade this money for non-emergency purposes. Sometimes folks use a Roth IRA as a dual-purpose account until they can establish separate accounts for retirement and emergency funds.
A Roth IRA could be used as your emergency fund, since you can withdraw your contributions to your Roth IRA at any time for any purpose without tax or penalty. I don’t recommend this option for long-term use, because if you have to get at the funds for an emergency purpose and you’re not able to replace them in the account within 60 days, you’ll lose the Roth treatment of those contributions forever. You can always put more into the Roth IRA at a later time, but once you’ve got the money in there, you shouldn’t take it out before retirement without a very, very good reason.
The most important tool for achieving financial success is knowledge. For this reason, I suggest that you use some of your new-found riches to improve your financial knowledge. There are many good books out there that will help you to better understand your finances and how you can improve things.
I wouldn’t suggest spending an extra $1,000 totally on education – maybe as much as $50 or $100 for several good books. This will help you to make good decisions with your remaining windfall.
If you haven’t maxed out all of your retirement savings for the year, such as 401(k) plans and IRAs, this is another good place to put an extra $1,000 to work. For an IRA or Roth IRA (if you’re eligible by your income level) it’s simply a matter of making the contribution to the account and investing it appropriately.
If on the other hand you haven’t maxed out your 401(k) plan, you can defer an extra $1,000 by your paychecks throughout the remainder of the year and earmark an extra $1,000 to make up the difference in reduced take-home pay. If you started in July and you have 13 more pays left in the year, you’d set aside around $75 per paycheck (if paid every two weeks) and your income will be reduced by a little less than that, since the money you deferred isn’t taxed.
Consider making a donation with your extra money. There are many deserving charities (I’m sure you can come up with a list of several without much difficulty) that would LOVE to have a donation of $1,000. And you can take a deduction on your tax return for the donation (assuming that you itemize your deductions).
Who Does Each Option Work Best For?
Folks who are just starting out in improving your financial situation quite often need to focus on all of the options I mentioned above – debt reduction, emergency fund, knowledge and retirement savings. The list was put together in priority order, so you should focus on debt reduction first, then emergency funds, and so on.
If you’re a little farther down the timeline and have eliminated all consumer debt and have established an emergency fund, improve your knowledge first, and then add more to your retirement savings. I mentioned before that the most important tool that you have is your knowledge. The most important action you can take to improve your financial standing is to increase your bottom line. We did this first when we eliminated all debt. The next step is to add to savings. Both moves will increase your net worth – your assets (savings and possessions) minus your liabilities (loans and other debts) equals your net worth. The key to financial success is to make moves that will have a positive impact on your net worth.
Students who don’t have any debt accumulated should focus first on the emergency fund, and then on retirement savings. In some cases it makes good sense here to put the money into a Roth IRA, since money in a Roth IRA won’t be counted on your financial aid forms, since it’s a retirement account.