What would you do if you came into some money? It could be from anywhere—an unusually large bonus or commission check, an inheritance, an insurance settlement, an income tax refund, the proceeds from the sale of a piece of property or prize money you won on a TV game show. Alright, that last one is a bit of a stretch, but how a windfall comes about isn’t as important as what you’ll do with it.
That’s an important decision too—knowing what you’ll do with a cash windfall before you actually get it. If you don’t plan out what you’ll use it for, you may end up regretting it later. Once money is spent, it’s gone and you won’t get a do-over.
For most people, there are four basic ways to use a bonus, and each carries its own set of rewards and risks.
Make a major purchase
When a cash windfall comes in the temptation is often to go out and buy something. Usually it’s something fun that makes us feel good, like a vacation, a wide screen TV or a room (or two or three) full of furniture. Often it’ll be used to buy a new car, even though the old one is just a few years old and in good running condition.
Reward— The basic reason you might do this is because it feels good! Let’s face it, if you live within a budget most of the time, having some extra money to burn feels like freedom—finally, you can buy what you want. It can also make your family happy, and that has benefits. Time spent having fun on vacation can build memories that last a lifetime.
Risk— More so than with the other choices, spending the money is usually an irreversible situation. Most of the things we buy are worth only a fraction of what we pay for them once we take them out of the store so it’s not like you can resell later and get your money back if you realize you made a mistake.
If you go this route, think about spending the money on something you need at least as much as you want. Replacing your 10 year old car with a new one is a purchase that will provide benefits for years to come. But take a luxury vacation that turns out to be less than luxurious and the money is gone for good.
Payoff debt
This can actually feel better than buying something new, especially if you’ve been struggling with debt problems.
Reward— By paying off debt you can make it go away for good. That means more cash flow on an ongoing basis, kind of like a dividend. Eliminating debt is also a stress reducer, which can not only improve the quality of your life, it can also free up your emotional energy to be more productive in other areas.
Risk— If you aren’t disciplined, you may end up going back into debt for the same reasons you landed there in the first place. Enjoy the benefit of having one less monthly payment, but don’t use the suddenly open credit lines to go on a spending spree that gets you back in debt.
Save it
If you have little or no savings, putting the money in the bank is your most critical need.
Reward— By saving the money in the bank, you can’t make a mistake that you’ll regret. If you change your mind later, the money will still be there complete with accumulated interest. There’s also a strong psychological and emotional benefit to saving the money: the cash will provide a cushion that can make your life easier. Just knowing it’s there is a priceless feeling.
Risk— Other than the fact that putting money in the bank is fairly boring, there really aren’t any risks here. It’s the safest way to handle a windfall.
Invest it
This has both greater rewards and risks than any of the others. You could end up with far more money than you started with—or you could end up with nothing!
Reward— The main benefit is the potential to grow the initial investment into something larger, hopefully much larger. If it does, you will reap the rewards for years to come.
Risk— When you invest money it usually has no immediate benefit. You can’t spend the money, it doesn’t provide the peace of mind that comes with a savings account, and unless you get lucky, it will usually take years for your investments to grow. There’s also the possibility of making a bad investment and losing some or even all of the money. That would be the worst of all outcomes because you will have lost the money for no good purpose. (Hint: be sure to diversify!)
You could also combine one or more of the above, but that would also depend on the size of the windfall, the amount of money you have otherwise and what your other needs are. Perhaps the best way to approach it is to think strategically. Ask yourself the question, “what would provide the greatest benefit over the longest term?”
What would you do with a cash windfall?
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.