I see this being asked all the time all over the Internet, from forums to Reddit. You have an extra couple hundred bucks leftover after all of your expenses, what should you do with that money?
It’s a great question and I always applaud anyone that has this mindset because it means that they know exactly how much their take home pay is and what all of their expenses are on a monthly basis. In other words, they are budgeting and have the confidence to stick with that budget consistently and aren’t looking to spend it all on a brand new TV or a pair of Christian Louboutin’s.
I know some of you are rolling your eyes when you hear “extra money every month”! As much as you think that you barely survive off of every paycheck, I can almost guarantee that there are monthly expenses that you could cut back on (check out the Monster List of ways to save money) to give you some breathing room, regardless of how much you earn.
I’ve said this before (and will likely say it again somewhere else) but I have met many people that earn a modest income that are much better off financially than those that earn significantly more. Sure it’s nice to earn more, but it’s not always about how much you earn, it’s about what you do with the money you earn that matters most.
So what’s the answer you ask? Well, like most things the answer is, it depends on your personal situation. So let’s go through the 5 steps!
To read in detail about each of these check out the Different parts of your portfolio article. As this article will give you an idea as to how you should structure your overall savings and investment portfolio.
Step 1: Grasp how much debt you have
The first thing I can say is that if you have credit card balanced of any kind, pay this off first! I don’t care if you have a “low interest” credit card, pay it off. And just so you know, that “low interest” isn’t low interest at all, it’s likely around 10% or more which is still extremely high.
Another thing to note is that when you are budgeting your expenses, don’t budget for the minimum payment of your credit card statement. You should be paying your credit card balance in full every month, no exceptions. Having a credit card balance is one of the worst financial decisions you could possibly make. The only thing that could potentially be worse is either putting your money through a shredder or putting it on fire, which I’m sure is illegal in most countries.
If you are carrying a balance try and read the statement the next time you get it. Somewhere on the statement it should say “If you only make the minimum payment every month it will take 324 years and 10 months to pay your full balance off” Ok I exaggerate, but the number will be mind blowing, I promise you.
I hope I hit the message home. If you are carrying a balance on your credit card and are paying 20% interest or something very high, go to your bank and see if you can get a consolidation loan to pay off the debt. A consolidation loan will allow you to consolidate, or put all of your outstanding debt into one loan to make it more manageable and allow you to pay everything off systematically. However, the bank will likely close your existing credit card, which makes sense since they don’t want you to pay off the credit card only to max it out again.
If you aren’t carrying a balanced on your credit card, then list out all of your outstanding debt in order of highest interest first. If you don’t know how much interest you’re paying, you have some homework to do! There’s also the option of paying off the smallest amount off first as well. As much as it makes more financial sense to pay off debt with the highest interest, it makes psychological sense to get rid of any debt, as there is a sense of accomplishment when you pay debt off.
If you haven’t set your short, medium and long-term goals yet spend some time doing this first, it will be time well spent. And take this activity seriously, I’m guilty of this too, but I have written goals down, like for New Years resolutions, only to break all the rules the following week. That’s why it’s important to create SMART goals.
Here are some examples of short, medium and long-term goals:
Short (~ 1 year):
Pay off debt, save for rainy day fund, vacation
Medium (2~5 years):
Car down payment, pay off student loan, down payment for a home
Long (5~ years):
Retirement/Financial Freedom, vacation home, children’s education
Step 3: Prioritize and Allocate funds for each goal
Every one of us has different goals, dreams, and priorities. When you list all of your goals and dreams, set priorities by giving each goal or dream a score from 1 to 10, 1 being lowest score and 10 being the highest score. By giving each goal or dream a score, you can visualize where you want to put your money much easier.
Now that you know which goals you are prioritizing, you can allocate funds accordingly. You can do this in one of two ways that work best for you. The first option is very simple where you set an arbitrary number for each goal. For example, if you have $500 excess cash every month, putting $100 per month in each of retirement, emergency, debt payments, vacation, and purchase funds.
The second option is to allocate a percentage to each goal. For example, let’s say you have $500 excess cash every month and you allocate the funds accordingly: 40% debt payments, 15% retirement fund, 15% house down payment, 10% emergency fund, 10% children’s education, 5% vacation fund, and 5% purchase fund. The beauty of this is that if your monthly excess cash changes you can allocate according to the percentage, let’s say $750 and the percentage (10% emergency fund =$75) and have complete control of where all your money goes. If you do the arbitrary amount, you might be tempted to use the extra cash on something that isn’t part of your plan.
Step 4: Putting your money to work intelligently
Money you are putting away for short-term goals and likely most medium term goals should be in liquid and secure investments. This means that you can access the money right away and you won’t lose any of your original principal. Unless you want to be very risky if you plan on using the money in less than 5 years it makes little sense to take even moderate risk with the money as you could lose a significant portion of that money depending on what you invest in.
So with short term and medium term goals you should look to savings accounts with higher interest rates, term deposits or possibly some sort of fixed income investments that are in line with your timeframe. If you must invest in stocks, and I know some will, do so at your own risk but you might smack yourself in the head when the market drops, and as you know the market does have dips.
Generally speaking, the longer the time timeframe, the more risk you can take obviously depending on your risk profile. If you don’t what your risk profile is, then determine that first by reading this article I wrote. Then you need to figure out how you are going to invest that money. It doesn’t matter if you’re going to do it all on your own or by simply let someone else do the work (mutual funds or getting an advisor), the key is to make sure you continue to put funds into that account on a regular basis.
Step 5: Review Periodically
Everything that you do with financial planning and investment management (well everything in life really) should be reviewed periodically. Once you hit a goal, then you obviously don’t need to put any more money into that account. Is your children’s education more expensive than you had initially expected? Then you might need to step up the amount you’re putting in regularly.
This might seem like more work than it really is. I was thorough, but the logic behind all this is very simple. Plan, prioritize, allocate, and review. That’s all there is to it!
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