Depending on the industry you work in and the type of job you have, there’s a good chance that you’ll be getting an end of year or Christmas bonus. If things have gone well for your company, your bonus might be a sizable amount. All you have to do now is decide how to use it- not a bad problem to have!
Of course, if you’re like most people, there’s a big part of you that would like to blow the whole bonus on buying all the things you’re really wanting or on having a good time. And there’s no reason you can’t spend some of it on fun. But there’s also a part of you that knows you should use at least part of your bonus on improving your financial situation. Take advantage of this once-a-year chance to give a little extra boost to your finances!
Should you Invest or Pay Down Debt with your Bonus?
The two best ways to take advantage of a bonus are to invest and to pay down debt. Both of these will improve your net worth, and will put you on the path to a more secure and comfortable future. But which is better?
If you have your debt firmly under control, meaning your debt is limited to low interest secured debt, such as a mortgage or car payment and you have no problems paying your monthly payments, investing is a great way to use your bonus. Stash some extra money in your retirement funds, and if you haven’t started a retirement fund yet, get one going!
However, if you struggle making all your monthly payments and you have high interest debt, you should likely use your bonus to pay down debt. The return on investment of paying down high-interest debt such as credit cards will almost always exceed any investment. Furthermore, high interest debt is a heavy burden on your finances, easily leaving you exposed to financial emergencies and budget shortfalls.
One way to look at your finances is as a building. Your debt situation is the foundation, and your investments are the walls. If you build spectacular walls while having a weak or crumbling foundation, the whole building will collapse at the first sign of stress. But if you first focus on building a good foundation by eliminating problematic debt, you will then have the means to invest consistently through thick and thin and weather market swings, leading to a skyscraper that can stand the test of time.
Using your Bonus to Fix Your Credit
Paying off debt is great, but can you also use your bonus to fix your credit at the same time? The good news is that you can! By strategically paying off debt, you can score an almost immediate credit boost, as well as paving the way for ongoing credit improvement.
Your credit consists of five metrics– your payment history, your total debt compared to your credit limits (also known as your utilization ratio), your average account age, the amount of new debt, and your credit mix. By far, your payment history and your total debt are the most significant factors in your credit score. Together, these two make up two thirds of your score. Because they are so important, we’ll focus primarily on these two.
A Quick Credit Score Boost
Paying down debt will have an immediate impact on your utilization ratio, since the ratio of total debt to total credit will go down. When the credit bureaus see your debt inching up towards the max, they see this as an indication that you might be close to defaulting on your debt and lower your score accordingly. So the more debt you pay off, the further you get from your max. The credit bureaus now see you as less likely to default and boost your score accordingly. The further you get from your maxes, the more your score will jump. This will take effect as soon as your creditors report the information to the credit bureaus.
Buckling Down for the Long Haul
Your credit utilization ratio is only part of the picture, however. Equally important is your credit history- whether you’ve missed any payments or made any late payments. The more payments you’ve missed or been late on, the more your score is affected. The effect of the ding also depends on how recently it occurred, with the effect decreasing as time goes on.
If you’ve always made all your payments on time, great! Keep it up! However, if you’re like most people, you have at least a few dings. Your goal now is to not have any more, and to make those missed payments fade into history.
The best way to do this is to decrease the total payments you have to make each month. Most likely, the reason you miss payments is because you had more payments than money left in your account. Eliminating payments will start eliminating this problem.
Eliminating payments sounds great, but how do you do it? By using a technique called the snowball debt pay-down method. The snowball method targets your debts in order of size, starting with the smallest. This way, you quickly eliminate a payment, freeing up money to pay your other monthly payments and perhaps even make extra payments. Once you knock out your smallest debt, you move on to your next smallest, and so forth. An end-of-year bonus can be a great way to get this snowball rolling, putting you on track to stronger finances and a better credit score.