Getting a tax refund is always a pleasant experience, but it's important to use (at least some of) the money wisely to achieve your financial goals. In this blog post, we offer some tips on what to do when you receive a large sum of money – for example, if you're getting a tax refund.
- Pay off expensive debt
Before you start investing or spending money, it's important to pay off any high-interest debt. High-interest debt, such as credit card debt or personal loans, can be a significant burden on your finances. If you're paying 16-18% interest on these types of loans, it makes more sense to pay them off rather than invest, as finding a 16% risk-free return elsewhere is difficult. Paying off expensive debt will also give you more financial security and an easier future. Compound interest is magical when you’re earning it—but much tougher when you're the one paying it. Mortgage loans typically aren’t considered expensive debt, but if you feel that this loan is also weighing you down, you can try paying a bit extra to get down to 60-70% loan-to-value and enjoy interest-only payments. This doesn’t usually pay off, but it’s nice to have more disposable income in the future when you're only paying interest. - Make sure you have enough savings buffer
After paying off expensive debt, the next step is to build your emergency fund. A savings buffer or an emergency fund (some call it a "F**K you fund") is essential for covering unexpected expenses like illness or job loss. The general rule is to have three to six months' worth of living expenses saved in an emergency fund. The exact amount you need to save will depend on your individual circumstances, such as insurance coverage, fixed expenses, and job stability. I recently met a young woman who had top-notch insurance, no car, a new apartment (usually fewer repairs with this), and few fixed expenses. She had three months' salary in her emergency fund and found that it was too much! If her washing machine breaks down, she can handle it with her regular salary, and she pointed out that it's possible to sell funds the same day if needed. - Invest the rest
Once you've paid off debt and set aside what you need for your emergency fund, you can begin investing the rest of your money. Investing in stocks or funds can help grow your wealth over time. Historically, equity funds have delivered much higher returns than your bank account! However, it's important to have a clear understanding of your investment goals and risk tolerance before you invest.
Many people ask us how they should invest when they have a larger sum to invest at once. It all depends on your risk tolerance. If you want to reduce timing risk, you can consider "phasing in" the money. Most people opt for some version of this.
Phasing in your investment, also known as "dollar-cost averaging," is a popular investment strategy that involves investing a large sum over time instead of all at once. The idea behind this strategy is to reduce the impact of market volatility by spreading the investment over time. If you invest all at once, you risk buying at a market peak. By spreading it over 3-6 months, you might catch some market declines—or you might miss out on better prices because you could have hit the bottom. You never know, but the average price tends to be more consistent.
While dollar-cost averaging can be a good strategy for some investors, it's important to note that it may not always result in the best returns. In some cases, investing all at once can yield higher returns in the long run, especially if the market is trending upward. The decision to phase in the money or invest all at once should be based on your individual circumstances, risk tolerance, and investment goals.
Getting a tax refund is always fun, but it's important to use it wisely to achieve your financial goals. Paying off debt, setting aside an emergency fund, and investing are all smart ways to use the money. Of course, you can treat yourself to something nice if you feel you need it, but most of us probably have enough things already? :)
