How to manage a financial windfall

It may seem like a problem you'd love to have -- receiving a hefty windfall and not knowing what to do with it. Frankly, it could be anything -- a Diwali bonus, an inheritance, an insurance settlement, the sale of a home or business, or even winning a lottery.

Photograph: Lisa Brewster/Creative Commons

What you should not do is squander it all on a reckless spending spree. Here are a few ways you can handle that bonus wisely.

1. Start an emergency fund

Use this money to start, or supplement, an emergency fund. In life, you should expect the unexpected -- job loss, sudden medical expenses, unforeseen emergencies. Having a reserve for a rainy day is a very good idea.

Without an emergency fund, you are more vulnerable to sudden life changes. Most financial planners recommend setting aside 4 to 6 months' worth of living expenses in an emergency fund.

If you take the liberal view of living expenses when deciding how much to stash away, your emergency kitty likely will last a little longer.

2. Clear expensive debt

In how to get out of debt, we gave some suggestions for those drowning in debt.

Any debt that does not give you a tax break should be cleared. So personal loans, home renovation loans, and auto loans should top the list. Education loans and home loans are the ones with a tax benefit.

If you have been running a huge debt on your credit card, clear it. At 2.5 per cent per month, it may appear deceptively manageable. Not so.

It amounts to an eye-popping 30 per cent per annum. What's more, every fresh payment made on the card has this rate of interest levied on it.

Not a good position to be in.

3. Prepay a home loan

If you are servicing a home loan, you would be aware that the equated monthly instalment, or EMI, is an unequal combination of principal repayment and interest payment.

In the initial years of the repayment, the bulk of the EMI is predominantly interest payments. The principal repayment takes place predominantly in the later years.

So if you still have a long way to go with regards to servicing your home loan, then use this money to pay back the loan.

Let's look at an example.

Repayment tenure: 120 months or 10 years

EMI: Rs 60,663.81

RoI: 8 per cent per annum

Loan amount: Rs 50 lakh

As mentioned above, an EMI is an unequal combination of interest payment and principal repayment. In this example, the interest payment in each EMI over the last three years will be less than 13,000 a month. However, in the first 18 months of the repayment tenure, the interest payment would be above Rs 30,000

So if your home loan is still in its initial years of repayment, then do use this bonus to clear some of it and lower the interest load.

4. Supplement your goals

If you have been keeping money away for the down payment of a home loan, or saving for a holiday or to purchase a vehicle, this money will come in handy.

Having said that, if you have a huge bonus or a big windfall, the entire amount may be more than sufficient to meet the above goal.

In that case, add this to your retirement kitty. Purchase stocks or units of mutual funds. You can do so in a phased manner or make a one-time buy.

5. Spend a little

Don't blow up the entire amount, but you can surely indulge yourself a bit.

In fact, if you allow yourself a small indulgence, the probability of blowing up the entire windfall or bonus is lesser.