Receiving a chunk of money back from the government at tax time is a double-edged sword. It can give a false sense of financial calm, leading you to make irresponsible choices you would never consider otherwise. Eventually, those can turn into expensive habits and an unsustainable lifestyle. The key is to have a solid plan from the start.
Step 1: Pay off high interest debt
The number one step to take after receiving a windfall is to pay off any high-interest debt, such as credit cards or personal loan bills. If the interest rate is eight percent or higher, you should always pay that off before doing anything else.
Step 2: Bulk up your emergency fund
Once you’ve cleared your most important debts, it’s time to focus on your emergency fund. Go through your bank accounts and determine how much liquid cash you have to use in case you lose your job, require an overnight stay at the hospital, or your car breaks down. Write down that number. Most experts recommend stashing at least three months’ worth of expenses, but if you have a home, an unstable job or a child, you should have between six to 12 months’ worth of expenses.
Step 3: Increase your retirement contributions
Adding money to your retirement accounts is a smart next step, because the money you invest will pay off when it’s time to stop working. The power of compound interest could turn your RSP into a goldmine.
Step 4: Pay off other debt
If you have a mortgage, car loan, student loans or personal loan, a windfall can help you wipe them out entirely. If you don’t have enough to pay off all your debt, there are two methods you can use to decide which ones to choose. The snowball method recommends paying off debts with the smallest balances first and using those monthly payments to add onto your other debts. Another popular strategy is the avalanche method, which advises consumers to pay off debt with the highest interest rate. Paying as little interest as possible will save you the most money in the long run.