Assess your personal situation using these guidelines

What should I do with 5k

A close friend of mine text me the other day literally, “Morning homie! What would you do with 5k?” He and I grew up together, and as great friends do, have stayed in touch approaching 20 years even after moving to different states.

He’s followed my financial journey through the ups and downs, and I’m always honored when he asks my opinion. I believe in quality over quantity when it comes to friends and he is a perfect example. Knowing that he has me to turn to and had this question, I figured others out there likely do as well, so hopefully I can provide a starting point into answering it.

No two financial situations are completely alike

I saw his text and thought to myself the same question, what would I do with 5k? Then it was evident, why am I asking myself this? There is no blanket answer for everyone. No two financial situations are completely alike. What would be appropriate for one person isn’t suitable for another, hence the typical request of a financial advisor to review your financial situation and your future goals.

Review your financial situation

10 years ago I was under the impression advisors just wanted to pry information out of you to see what free capital they could tap into, maybe some do, but as I continue to review my own financial situation I realize where you are and where you hope to be going are key inputs into the metrics of your financial journey.

I’m sure a few of you are sitting there thinking, “Why even ask where do I want to be? Rich and retired on a beach, duh!”. Well there’s usually stepping stones and an order of things to get you there. Here’s how I think about allocating extra money and how I look to organize my path to join you there.

Get financially educated

I realize some of this may get a bit technical for some, but I want to espress 😉 how I actually thought about this question. If some of this goes over your head, search for the terms I use at investopedia for more information and to become more financially literate. No shame at all, we all have to start somewhere. I often find myself there refreshing and confirming information as well.

Start with high interest debts

I’d first start with my debts. How much do I have and at what interest rate? Is that rate fixed or floating, meaning does the rate increase as market rates increase and what rate are they pegged to, such as Libor or Prime, or do they stay the same during the time you’re borrowing the funds (fixed). Floating rate loans are typically issued at the Prime rate plus an additional rate to compensate the lender for your credit risk to borrow – i.e. the likelihood that you’ll default, meaning not pay them back.

Next, I look at what is the current interest rate environment and where do I think they’re going. Let’s be real, if I knew that answer I wouldn’t be here writing this blog, I’d instead be on the Forbe’s 400 list bumping elbows with Buffett during conversations of how I timed the interest rate market, but hey, I still like to think I have some view on where rates may be heading. Everyone’s got an opinion, you know the saying…

Anywho, then I look at the type of debt. Is it a mortgage, credit card, student loan, car ect.? I’m the kind of person that believes cash is king and likes having cash on hand as often as possible. Not physical cash – 1, That’s old school. 2, We need to earn at least some interest on our money to slow down the effects of inflation. I’m talking zeros in the bank. I want to be able to seize the opportunity when a great deal or investment presents itself.

I’m going to look to pay off the highest unsecured adjustable rate debt before anything else. I’m talking those credit cards that run into the teens and often twenties in the interest rates they charge. The idea here is that finding a safe investment with the likelihood of earning say a 25% return on investment is pretty low for us average folks, so it wouldn’t make sense to borrow at 22.99% APR and say invest in a 30 year corporate bond that yields around 4%, or to put the money in a savings account earning near zero while that credit card racks up interest daily. Not smart to carry high interest debt in most cases. I’d pay that off asap. I’ll tell you how I paid off 55k of debt in 14 months in a future post.

Look at all debts outstanding

Next I look at my other loans, such as car or student loans. I fortunately, or unfortunately however you want to look at it, never had student debt. I instead chose to work 3 jobs to put myself through college, budget my food to near $30 a month, drove a beat up Hyundai Elantra that my parents gave to me in fear of killing myself on my motorcycle, and slept 4 hours a night. Impossible you say? That, and more frugality details in future posts.

I have talked to others about their student debt, and the ones I’ve talked to tend to have loans extending out over 10 years at rates around 2-4%. Not too bad, I’d likely keep in exchange for investable cash. If the rates on the loans are any higher I'd look to pay them down.

Car loan rates can vary. If you have not so great credit you could be paying a high rate. Personally, anything over 6% and I want it paid off fairly quickly. A friend recently got a car loan at 3.99% and I was supportive of their decision. Now before all you FIRE people tell me to never have a car loan or borrow at that rate, not everyone wants to live like a pauper, and it made sense for their personal situation.

If you look at the inflation adjusted rate they’re borrowing at for 7 years, the real rate is closer to 1.5% based on the CPI index of 2.5% as of this writing early 2018. Taking out a loan instead of paying for the vehicle in full at time of purchase freed up cash and reduced their taxes for their business.

Focus on optimizing large monthly expenses

Next I’d look at my living situation. Am I renting? Do I have a mortgage, if so what rate? The majority of people’s largest expense is something that, I believe, needs to be the primary focus of the financial picture.

This is absolutely subjective and needs to be adjusted to each person’s preference. If I was planning to live in the same place for the foreseeable future, then I’d be looking to buy a reasonable home, below my means. Meaning, I don’t let the lender tell me what I can afford. I need to know how much I can afford when factoring in the mortgage, property taxes, insurance, and upkeep.

A rough rule lenders use, is the full mortgage payment, property taxes, and insurance, shouldn’t be more than 28% of your gross income. Here’s a cool tool I like to use to estimate these costs. I take it a bit further and consider utilities and maintenance as well, so I have a better idea of what my true expenses will be. Large utility bills and things like pool maintenance can take people by surprise after they thought their budget gave them enough cushion.

Rents generally increase yearly with inflation. When you own your home you lock in your payment when you get a fixed rate mortgage, and you’re paying the mortgage down with cheaper dollars. In theory, one’s salary should raise annually with inflation, so typically around 2%. I’ve proven that theory wrong many years, so don’t feel bad if you’re not getting a raise each year. I’ve been there too. But you should be doing something about it! This blog is a good start 🙂

Here’s an example:

You borrow 200k @ 4% for 30 years. Your mortgage payment is $955 a month.

Let’s say your current salary is 50k.

If your current salary only grows at the average inflation rate from the last 10 or so years of around 2%, then in 10 years you should be earning around $60,950, or about 22% more than you are today all the while your mortgage payment stays the same reducing it to about 1.6% of your gross earnings in 10 years.

Let’s say you decide to rent because you don’t want the hassle of home ownership, and you want more location flexibility. I’m not going to sugar coat it, owning a home is work. You will never be bored and will always have a project, so you’ll have to pick your poison. Compounding the rent payment, if it happened to be $955, would be $1164 in 10 years remaining consistently 1.9% of your gross earnings.

This is one way home ownership can help build wealth, even ignoring any price appreciation in the home, or tax benefits from writing off mortgage interest. I’m already going on too much of a tangent to discuss these added benefits at this time.

On the flip side, maintenance expenses can wipe out the benefits of owning at times depending on the age and condition of the property, especially if it’s in an area that tends to not see much appreciation. Some years these expenses could be almost nothing, while other years it could be many thousands. I’ll help break down these expenses in a future post.

If you prefer to travel maybe a home isn’t even in your future. We’re seriously considering this choice. This is why having a longer term view on life is important, and one size can’t fit all financially.

Look to invest

My buddy fortunately has zero credit card debit, no student loans, and is borrowing at 2.49% for his vehicle. Pretty solid financial picture. I then ask his future plans, specifically if he knows if he’s going to buy a house in the near future. If not, I’d likely contribute that money to a traditional IRA and invest in index funds to reduce current income tax liability.

Reduce your taxes

Depending on the state you live in, and your tax bracket, another dollar earned could mean owing upwards of an additional 40+% of that dollar towards federal, state, and local taxes. Again going back to not being able to find a safe investment yielding that kind of return, I think it best to pay less in taxes whenever possible as opposed to just saving it and losing a portion to taxes. But you need to have liquidity (spendable cash on hand), so stocking away cash for retirement, that can’t be touched for many years to come, isn’t always feasible if you think you need the money sooner.

Analyze and make a decision

My friend who asked what should I do with 5k talked about his plans to move in a few years and buy a home after relocating. I told him about Discover Bank’s savings account that, as of June 2018, currently offers 1.6% APR, which I personally use and have had a good experience with for years. It sounded like he wanted a safe place to park his money while he planned his next large move out of state in anticipation of buying a home. It would be hard to justify putting it into the stock market or a CD if he wanted access to the funds in the next year or two.

Debts and liquidity

There’s so many things he could do with that money that we didn’t talk about. Each person’s situation and the timing of the markets are something to consider. Needing access to the money and one’s current debts are probably the two key questions to ask yourself before determining the options.

Hindsight is always 20/20, and predicting market moves, of any kind, could be considered a fools game. The best one can do is look at as much information that’s relevant to them as possible, and prioritize what’s important to them to judge what direction to take. There’s a right time to buy and a right time to sell, and sometimes waiting for another day to reassess makes more sense than either one. Look at your own financial picture and know that one size doesn’t fit all.

I hope this helps give you a starting point for an idea that’s best suited for you.

What would you do with 5k? Am I thinking about this completely wrong in your opinion? Let me know in the comments below.

This is not financial advice in any capacity, as no one contributing to this blog at EMK is a licensed financial advisor, attorney, or certified public accountant, and no portion of the blog content should be construed as financial, legal, or accounting advice. Please consult a licensed professional before making a financial decision.