Do you ever watch those TV game shows where the winner takes away a cash prize and the host asks them what they’re going to spend it on? I’m waiting for someone to say “I’m going to beef up this year’s ISA with it, grabbing myself a few tasty looking blue-chip dividends“. But no, they’re always going to learn to play the tuba, or repaint the dog, or something.
I can understand how tempting it is. After all, a £10,000 windfall would buy you a very nice round-the-world holiday, or a decent car to replace your clapped-out old banger. Or 714 Wicked Variety Buckets from KFC (and please don’t ask me what they are — the name alone makes them sound too horrible to contemplate).
How much are you paying?
But wouldn’t it be great to hear “I’ll pay off my credit card bill with it“? Carrying credit card debt is one of the biggest financial mistakes you can make, and it’s where any spare cash should go before you think of anything else. Even a number of the established credit card companies are charging annual interest rates at around the 30% mark, and that adds an awful lot of cash onto the price of whatever it is you’re buying.
So before you think of spending a penny of any windfall on anything else, you owe it to yourself to get those credit card debts down — and you should really get rid of all debts other than your mortgage before you think about investing.
Next up should be some cash to cover emergencies, but how much? Conventional wisdom is that you should keep the equivalent of around three months’ expenditure in a quick access savings account, and that’s probably about right.
ISA time!
Once you’ve got your debts sorted and you’ve accumulated a sufficient rainy-day fund, you’re getting into serious investing territory. It’s then time to turn to an ISA — and I mean a shares ISA and not a cash ISA. An ISA currently allows you to invest up to £15,240 a year and have most of the returns protected from tax — so if you buy shares today and they’re much higher in value in 10 or 20 years time, or whenever you retire, you won’t pay a penny in tax on the gain.
Why shares and not cash? Well, for the past century and more, money invested in shares has beaten cash hands down. Today, you might get 2-3% interest per year from your bank if you’re lucky, but there are top FTSE 100 shares out there offering 5 to 6% and more in dividend income alone — we’re talking of companies like GlaxoSmithKline which paid 5.8% in 2015, Legal & General on a prospective yield of 5.4%, and SSE on a forecast 5.8%, and these aren’t high-risk outfits that are going to go bust tomorrow.
Shares will trash cash
The difference is a big one. If you could get 3% from cash savings, you’d turn your £10,000 into £18,000 in 20 years. But a dividend income of 5% per year would turn the same money into £26,500, and that’s before any share price gains. If you achieve a very modest 3% gain per year in share prices in addition, you’ll be sitting on £46,600 after two decades — and even an extra 1% above that would take you up to £56,000.
And £56,000 of future cash is a lot to sacrifice on a short-term treat (unless you’re already a successful investor and your future comfort is already secured, in which case go blow the cash and have fun!)