Congratulations on your pay raise or bonus. Now it’s time to get serious about how to use that extra money to improve your finances.
Before you’re tempted to spend a windfall on something frivolous, consider how it could be used to create more financial security instead. In this post, I’ll cover 6 strategies to wisely manage extra money so you don’t fritter away an exceptional opportunity to improve your finances and build wealth.
6 Strategies to Manage Extra Money Wisely
One of the first impulses we usually have after getting a bigger paycheck – or any unexpected income for that matter, such as a tax refund or inheritance – is to upgrade your lifestyle. Maybe you’ve been thinking about buying a bigger home, moving into a better apartment, getting a new car, or joining an exclusive gym or country club.
Increasing your expenses to match your income is called lifestyle creep. It’s one of the biggest danger to your financial future because it doesn’t seem like a bad or crazy idea at the time.
You might believe that you deserve to buy something pricey or make a luxurious lifestyle change after working hard for your raise or bonus. And maybe you can afford it on paper.
I’m not saying that you shouldn’t enjoy your additional income. But what I recommend is that you take a hard look at your finances and use this opportunity to strengthen your foundation before committing to a bigger expenses or luxury purchases. Letting extra cash slip through your fingers to finance a more expensive car loan or pay more rent means that you will miss a huge opportunity to build long-lasting wealth.
1. Fortify your emergency fund!
The best way to make sure you’re ready when bad luck strikes, is to prepare for it today. No matter if you have a small unexpected expense, like a car repair, or something major like getting sick or losing your job, you need a financial safety net.
Devastating events are tough enough to handle without also being stressed about money. When you don’t have a financial cushion to soften the blow of a large expense or a loss of income, you end up relying on credit cards.
Yes, it is good to have credit as a last resort, but please understand that it is an expensive option because high interest gets added to your balance every month until you pay the entire balance. For many, using a credit card as an emergency backstop puts you in a huge financial hole that can take decades to climb out of.
This is why your number one financial priority before doing anything else, such as investing or paying down debt, should be to accumulate an emergency fund. Studies show that 46% of Americans could’t come up with $400 to cover an unexpected expense. I don’t want you to be a part of that statistic.
Having at least a couple months’ worth of living expenses and ideally a minimum of 6, on hand gives you a tremendous amount of peace. You’ll know that you’ve got money to deal with just about any distressing situation that blows into your life.
So, if you don’t have a healthy emergency fund sitting safely in a bank savings account, use every bit of your pay raise or bonus to start building one. Get a tax refund? Pile it on top and feel empowered.
Don’t worry if your cash reserves earn little or no interest in the bank. They’re not supposed to. The purpose of emergency savings is to be accessible and liquid in the short term. If you invest your emergency money, the value could shrink to nothing the moment you need it.
2. Fill your insurance gaps
In addition to using extra income to create a financial cushion in the bank another critical way to protect yourself and those you love from something unexpected jeopardizing your financial security is having enough of the right types of insurance. Without it, a catastrophic event – such as a health problem, car accident, natural disaster, or a death in your family – could wipe out everything you’ve worked so hard to earn.
It’s not pleasant to think about what bad things could happen, which is precisely why so many people are under insured. But managing different types of risk is easy, in financial sense, because most of them can be transferred to an insurance company.
Health insurance is the most important coverage to have because any kind of medical issue or accident could leave you with a massive bill. Even a quick trip to the emergency room or a short hospital stay could cost thousands of dollars.
No matter what changes the Trump Administration makes to the Affordable Care Act, you still need a health plan to protect both your health and your finances. If you don’t get health insurance through work, use a resource like www.insurancequotes.com or www.healthcare.gov to find out your eligibility for benefits including Obamacare, Medicaid, Medicare, and the Children’s Health Insurance Program (CHIP).
Disability insurance is another important, yet often-overlooked, coverage that every earner should have. It provides a percentage of replacement income if you’re unable to work due to a disability, illness, or accident.
Remember that health insurance only pays a portion of your medical bills; it doesn’t pay for living expenses, like housing or food, if you can’t earn money for an extended period. If you don’t have disability through work (or you do but it’s not sufficient), purchase a policy and have enough emergency money set aside to tide you over until coverage begins.
Life insurance is critical when your death could create a financial hardship for those you leave behind, such as a spouse or children. It can help put kids through college, pay off debt, or just provide daily living expenses.
There are different types of policies, but the most common and least expensive option is term life. It gives one or moe of your beneficiaries a cash benefit if you die during a set period, such as 10-20 years.
Auto insurance is a collection of coverages that protect you and other drivers in your household. A minimum amount of liability is required by most states because it pays for your legal obligations if you damage someone’s property or injure them in an accident.
However, in many cases having minimum liability limit isn’t enough to cover the total value of all your assets if you were involved in a lawsuit. So, review your coverage and use your extra income to boos your coverage when needed.
Homeowners insurance is a requirement when you have a mortgage. It covers the structure of your home and your personal belongings anywhere in the world up to certain limits.
But just like with auto insurance, the liability portion may not be high enough to protect you. It would pay legal or medical expenses if a guest is injured on your property or if you hurt someone off premises and get into a lawsuit.
Renters insurance isn’t a requirement, but it’s one of the best financial safety nets you can have. Not only does it cover your personal belongings up to certain limits anywhere in the world, but you also get liability coverage if someone gets hurt in your rental or you hurt someone off premises. The average annual cost is just $188 per year – that is an insurance bargain.
You work hard to build wealth and have a comfortable life, so remember to protect it from tragedies – like accidents, illness, natural disasters, and theft – by reviewing your insurance needs each year and boosting coverage when needed.
3. Increase retirement account contributions at work
After you’re prepared for the unexpected by having emergency savings and insurance, the next strategy to manage your extra income wisely is to boost your retirement account.
You already know that contributing to you 401k, 403b, or 457 retirement plan at work is a good idea- especially if you’re getting additiona free matching funds from your employer. If your contributions are set as a percentage of income, you’ll automatically save more, and get more matching, as your income goes up.
But if your retirement contribution is a flat dollar amount, such as $50 per paycheck, it won’t increase unless you make the manual change online or through your benefits administrator. Getting a pay raise is the perfect time to kick up your contribution.
If you make $50,000 per year and get a 3% raise, you’ll earn an additional $1,500. That’s an extra $125 per month before taxes. If you contribute that amount every month for 30 years to a traditional retirement account with an average 6% return, it will grow to over $125,000.