Remember, loans come first. If they are high-cost ones like credit card outstandings or personal loans, so do clear those first.
How would you spend your annual bonus?
This is a question that most of us would love to be asked more often than just once a year. But jokes apart, a bonus undeniably has a positive psychological and feel-good impact on the person receiving it. For many, it seems like a well-deserved recognition for their unstable work-life balance.
If you have received one in the past, you will surely understand what I am talking about. And there is no denying that spending this windfall is a tempting option. Most people start planning much in advance about how to spend it.
I'm aware that asking to not spend it would be asking for too much. But I think it's important to understand why you should try to maintain a fine balance between enjoying it (by spending) and allocating it towards important financial objectives.
Remember, loans come first. More so if they are high-cost ones like credit card outstandings or personal loans.
1. Clear off expensive loans
Credit card debts are the most expensive and charge up to 30-40 percent. Personal loans aren’t cheap either and range from 15 percent to above 20 percent. There is no point paying high interest if you can avoid it. And there aren't any tax benefits for these loans either. So assess the cost of pre-payment (as some have prepayment penalties) and partly or fully close these loans first.
2. Review life and health insurance
Not having the right life and health insurance in your financial portfolio can be disastrous. Unlike investments, the luck plays a bigger role here and it doesn't give too many chances to get it right.
Most people are underinsured when it comes to life insurance. As for health insurance, they are either underinsured or dependent on employer-provided coverage.
If your existing insurances are insufficient, then it would be wise to correct this problem using some of your bonus money right away. And yes, your insurance premiums also provides tax benefits if that interests you.
(Tip - If you find it difficult to pay premiums, then start an RD to accumulate money for insurance premiums).
3. Start an emergency fund
Do you have some savings for emergencies? Like a sudden expensive repair work, uncovered medical expense, sending money for family member’s emergency or even a temporary job loss?
These are financially scary situations and it's advisable to have some money earmarked solely for such emergencies.
Ideally, you should have about six months monthly expenses in an emergency fund. But if you are just starting, then it's a good idea to allocate a part of your bonus for this emergency corpus upfront.
4. Prepaying home loan
Using bonus to prepay the home loan is fairly common. But there is no need to go overboard. First take care of the three things discussed earlier. Once that is done and if you wish to clear the home loan soon, then consider using the bonus to prepay it.
How does it help?
Suppose you take a home loan of Rs 50 lakh at 9 percent for 25 years. Your EMI will be approximately Rs 42,000. Now if you are able to use (let's say) Rs 1 lakh from annual bonus every year for prepayment, the loan can be closed in the 16th year itself. You also save Rs 30 lakh on interest payments. Can't spare Rs 1 lakh every year? Then even Rs 50,000 annually from bonus towards home loan prepayment can save Rs 20 lakh when compared to not making any prepayments.
One must consider the opportunity cost of prepaying the home loan. So if some investment opportunities can give a higher rate of return than the loan rate in long term, then there is a case for investing the bonus money than prepaying the home loan. The money invested can be towards mid- and long-term financial goals (like children's education, retirement, etc). But the decision can vary from person to person.
5. Spend too
Remember it's a bonus. So you should spend some of it too and not feel guilty about it. Take a small holiday or make that purchase you've been putting off. But don't go overboard and keep in mind all the other points discussed earlier.
Although there isn't a perfect rule on how to spend your bonus, it's your money and you can spend it as you want. But for most people, having a balance between spending it on discretionary expenses and using it to reduce debt, save some for emergencies and goals, should do the trick. As for what ratio of saving vs spending of the bonus works best, you are the best judge.(Dev Ashish is a SEBI-registered Investment Advisor and founder of StableInvestor.com.)