Let’s say you used the ideas we discussed yesterday to save $5000 in 12 months. Now you are lucky enough to ask what to do with 5000 dollars?
We’re going to go through a process to help you know exactly what the answer is in just a minute. But before I get into it I want to assure you of one thing. No matter what your situation is. No matter how much or how little money you have. The following process will help you decide what to do with your next $50 or $50,000. Let’s get going.
1. High Cost Debt
Before we worry about buying a diversified portfolio, we need to take on debt. Other than your mortgage or other special very low cost debts, you should get rid of debt if you have the money to do so. If you have $5000 and owe that much or more, use all the $5000 to pay down that debt. If you don’t have the entire $5k but do have extra savings each month, use that money to pay that debt off as you get it. Don’t wait until you save up the entire amount.
Why pay off debt first?
When you pay down debt it’s like earning the amount that you would pay your creditors. And that’s a guaranteed return.
For example, if you owe MasterCard $5000 and the interest is 9%, you make 9% by simply paying them off because you are keeping the interest in your pocket rather than paying it to them. Where else are you going to make 9% guaranteed with no risk? (If you know someplace, email me. I’ll give my private 24/7 Pilgrim Hotline number.) Enough said.
Let’s look at the next place to put your $5000 assuming you have no debt.
2. Emergency Fund
No matter who you are, you’re going to have unexpected expenses. You can be ready for them by having a sufficient emergency fund. I don’t abide by the old “put aside 6 or 12 month earnings” adage. The amount you need for your emergency fund varies based on how stable your income is, your age, health and whether or not any big changes are coming in your life.
But if you are looking for a quick answer, look back at your bank records. What is the greatest amount of money you ever had to tap into unexpectedly over the last 10 years? That could be the amount you should set aside as your emergency money. While that’s no guarantee, it’s a pretty good indication of what kind of emergencies you are likely to run into going forward.
Assuming you have your emergency fund set up, what’s next?
I am not a huge fan of savings or CD accounts because they pay almost nothing. But there is one exception. If you have short-term or mid-term financial goals, you absolutely must use savings and CDs. These “investments” don’t pay very much interest as I said but they do provide absolutely security and some degree of liquidity.
If you need your $5000 within 6 months – keep the money in a savings account. If you need the money in 6 months to 3 or 4 years, tap into the security of CDs. As I said, the interest they pay completely stinks but the liquidity and safety are worth it.
Let’s assume you’ve handled your short and mid-term needs. We’re ready to move ahead.
If you have $5000, no debt, an emergency fund and your short-term and mid-term needs taken care of, it’s time to make some investment decisions. No need to invest to achieve your long-term goals. That being the case, let’s consider long-term investments.
You can invest in bonds of course but I strongly advise against it. The interest they pay is very low right now and you run the risk of losing a great deal of capital if interest rates rise. Not a good tone.
Real estate is attractive in my opinion but it’s hard to invest in property with $5000. You could buy a REIT but I think these stink for too many reasons to go into detail here. We’ll leave that for another post.
This leaves you with mutual funds and ETFs. I believe these are great alternatives for long-term investment needs. Even if you don’t have the entire $5000 right now, you can easily invest a small amount each month to build up your account. Just make sure to pick funds or ETFs without transaction costs. Paying $9 or more dollars on a $450 transaction is very expensive.
Consider using Scottrade to make these investments because they have an extensive list of funds and ETFs that you can buy without paying any transaction fees.
What if you don’t know how to invest the money?
If you like the idea of investing for growth but have no idea as to how to invest, consider using a service like Betterment. They are inexpensive and they take the guess work out of investing for you. They just ask you a few questions to help you decide the risk-level you are comfortable with. The other benefit this option provides is that you’ll learn how to invest as you invest. It’s a fantastic place to begin your investing career.
Note: For amounts greater than $25,000 however I think there are far better alternatives and I’d consider hiring a financial advisor to help you make investment decisions instead.
A cheaper alternative is to simply buy an index fund and hold on to it. I don’t like this choice because it doesn’t give you any diversification and you don’t really learn about investing but you should know that it is available.
You can see that if you approach your finances in a systematic way, the answer of what to do with $5000 isn’t so complicated.
What would you do with $5000? Would you forget everything mentioned above and just go to Vegas or buy a super deluxe TV set instead?