What Should You Do with Your Stimulus Check?

Economic stimulus payments, which many households began receiving this week, give you an opportunity to demonstrate just how good a capital allocator you are. (To determine whether you're likely to receive a stimulus payment, check out the IRS' calculator.) Is it better to spend the windfall, save or invest it, or use it to pay down debt?

Before you decide, you owe it to yourself to consider how to wring the highest possible return out of that windfall. There aren't any one-size-fits-all answers, but here are some of the key factors associated with each route. (I've ranked them from low to high return potential.) You'll note that I haven't included the option of giving the money away, either to a relative in need or to a worthy charity. Gifting the money is a worthy option, of course, but because its benefit can't be quantified (apart from the deduction you'll earn for contributions to qualified charities) I haven't included it here.

Option 1: Spend It
Return Potential: Low to none.
The government wants you to hit the stores in support of the economy, but your first obligation is to support yourself and your family. Of course, if you have daily expenses to meet, you have no choice but to spend the money. And if you've been using a high-interest-rate credit card to fund day-to-day living expenses, by all means spend away to buy any essentials that you need.

Also in the category of worthwhile expenditures would be maintenance to protect valuable assets. Getting your car fixed or making a worthwhile home repair you've been putting off qualifies, as does paying for anything that will help you improve your health.

Expenditures on discretionary items, however, look a lot less compelling from a return-on-investment standpoint. I'll save you the lecture, but overzealous spending is what got us into this subprime mess in the first place. And whether it's a flat-screen TV or a fabulous handbag, most everything you buy is a depreciating asset (unless you've got a can't-miss eye for rare coins or up-and-coming artists, that is). Sure, some retailers are offering gift cards for those who plunk down their whole stimulus check in the store, but most of the offers I've seen amount to a lowly 10% savings on your purchase--not all that compelling, in my opinion.

Option 2: Save It
Return Potential: Moderate to low.
In a shaky economy, one of your best uses of capital is to make sure you have an emergency fund in place--several months' worth of living expenses tucked in a highly liquid account such as a money market fund or CD. Such a cushion can be a godsend if you lose your job or are confronted with a large, unexpected bill such as a car repair or a medical expense. If having an emergency fund keeps you from having to charge such an expense on your credit card, your net return on this money is quite high.

Conventional financial-planning wisdom holds that you should stash three to six months' worth of expenses in your emergency fund, but I'd ratchet up that amount if you have reason to believe that your company is on shaky financial footing or if you earn a high level of income. (It typically takes longer to find a high-paying job than it does a lower-paying one.) Your stimulus check won't get you all the way there, but it's a start.

Beyond building your emergency fund, however, be careful about keeping too much cash on the sidelines. Yes, CDs and money market funds and accounts are a low-risk parking place for money you can't afford to lose, but "cash" returns are also quite low, especially right now. Current CD and money market rates are less than 3%, below the current rate of inflation. (The consumer price index is running at a roughly 4% rate.) That argues for investing rather than saving any amount above and beyond your emergency fund, because your investments will have at least a fighting chance at exceeding the inflation rate. It also argues for wringing every last fraction of a percentage point out of your short-term assets. If you invest in a money market fund, focus on the ones with the lowest expense ratios. (For more on getting the most out of your cash assets, see this article.)

Option 3: Invest It
Return Potential: Variable.
If you have already established your emergency fund, one of the best things you can do with your stimulus check is to invest it. Long-run bond returns have been in the neighborhood of 4% to 6%, and long-term stock returns have run about 6% to 10%--appreciably better than you'd earn in ultrasafe investments like cash. Thus, if you invested your $1,200 stimulus check in  Vanguard STAR and earned a 6% average return over the next decade, you'd have $2,085 at the end of the period. Your assets would have the potential to grow at an even faster clip if you made additional contributions.

Of course, you also ratchet up your risk level--and indeed risk real losses--by investing in stocks and bonds rather than supersafe money markets and CDs, so it pays to do your homework. For Morningstar's best stock ideas, check out our list of 5-star companies. Fund investors can look at our list of Analyst Picks to home in on our fund group's highest-conviction picks. (Both stock star ratings and Analyst Picks are features of our Premium Membership.) Russ Kinnel will share his best rebate-worthy fund ideas in his Fund Spy next Monday.

To help magnify your investment returns, invest in a tax-advantaged account like an IRA or a 529 college-savings plan, both of which allow tax-free qualifying withdrawals. The Roth is going to be the most advantageous option for most IRA investors, but see this article for advice on determining which IRA type is the best fit for you. For help finding the best 529 college-savings plan, read Marta Norton's recent roundup of the best and worst.

Also, if you have only a small sum to invest, beware of paying sales charges or brokerage commissions to make your purchase. True, many "load" mutual fund companies offer funds with very low minimums, and brokerage firms don't typically have a minimum purchase hurdle to get started in stocks and exchange-traded funds, either. But if you plan to add additional money to your account down the line, you'll pay those sales charges for each additional purchase. Over time, all those transaction costs can add up, watering down your long-term return. If you have only a small amount to invest, opt for a no-load mutual fund or hold the money in cash until you've amassed a meaningful amount (at least $1,000).

Option 4: Pay Down Debt
Return Potential: High to moderate.
If you're carrying a balance on a high-interest credit card and don't need to use your stimulus check to pay your day-to-day living expenses, your answer is a simple one: Pay it off. The reason is straightforward, and it's that any other expenditure or investment is unlikely to out-earn the amount you're paying to service that debt. True, you can typically transfer your high-rate credit-card balance to a low or no interest-rate card, but you'll have to pay the balance off in less than a year or the rate will shoot right back up again.

I'd also dispute the notion--advanced by some financial "gurus"--that individuals with high credit card bills should build up an emergency fund at the same time they're paying off debt. True, there may be some motivating psychological benefit to saving a little while you're trying to pay off debt, but the math behind such a strategy just doesn't add up.

The calculus gets a little trickier when it comes to using your windfall to pay extra on your mortgage. Not only are mortgage rates typically lower than is the case for credit-card debt, but you'll also receive a tax deduction on any mortgage interest. However, the case for accelerated mortgage payments is strong for those who also have to pay private mortgage insurance; for such individuals, increasing their home equity will lead directly to the elimination of PMI and, in turn, lower monthly bills in the future. Check out this article for a complete discussion of whether to prepay your mortgage.

How are other Morningstar members planning to spend their rebate check? Join the conversation on Morningstar.com's Discuss. 

 

 

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