So I heard you just received a promotion, and it comes with a pretty good raise. First off, congratulations! I had faith in you, and didn’t doubt for a second that your efforts would eventually be realized. Second, what do you plan to do with that extra cash (after you buy a Roomba, of course)?
Knowing what to do with your extra cash—whether it’s a big chunk of money, or a little bit from each paycheck—can be challenging. Typically, when our clients here at Flagstone have debt, they wonder whether they should invest the extra cash, or make extra payments towards their debt. There is a lot to consider before deciding which option would be best.
First, make sure you have the basics down. You should already have a sizable emergency fund set aside – about three to six months of expenses. Exactly how much you have in your emergency fund depends on your job stability, the job outlook in your industry, whether you have a working spouse who could support you, how much you spend, and more. If you haven’t met your emergency fund goal yet, focus on that.
You should also be adequately insured. You should have the proper property and casualty insurance, medical insurance, and probably an umbrella policy. Depending on your season of life, you might also need some sort of combination of life insurance, disability insurance, or long-term care insurance. If you don’t have the basic insurance policies, any debt reduction plan or investment plan (retirement or otherwise) can be completely blown up by a disability, a death, or other unforeseen events.
The last “basic” I’ll mention is to take advantage of any match in an employer-sponsored retirement savings account. For example, if your employer matches 100% of whatever you put in to a 401(k) up to 5% of your salary, the “basic” guideline assumes you are contributing at least 5% of your paycheck.
Now, let’s say you have the basics down. Should you be contributing more to your 401(k)? Should you be paying down your student loans quicker? Should you be paying down your mortgage quicker? Should you be investing in a non-retirement account? Here are some factors to consider.
1. What is the rate on your debt, and how does that compare to your expected returns in your investment account?
If, for example, your mortgage interest rate is only 3.125%, but your expected return in your 401(k) is 6.5%, when you do the math, you’d likely come out ahead in the long run by contributing extra to your 401(k). However, if your mortgage interest rate is 5.0%, while your 401(k) is invested conservatively and you only expect to earn 4.0%, then consider paying extra towards your mortgage.
2. What are the tax implications of each option?
If you’re investing within a tax-advantaged account like a 401(k), an IRA, a 403(b), or others, you should consider that those tax advantages. Now isn’t the time to go in to those details (although you can find some of my comments on those tax advantages in this article), but suffice it to say, often times the tax benefits are significant. Other times, you may not even qualify for the tax benefits, so be sure you’re talking to a professional before deciding solely based on the tax characteristics of an account. Consider the tax implications of paying down debt early, too. Sometimes, interest paid on mortgages or home equity loans can reduce your tax bill, although with the changes to the tax law that occurred in 2018, few people will actually see any tax benefit to interest paid on mortgages. Also consider the tax benefit of interest paid on student loans. Student loan interest payments are sometimes deductible, and unlike mortgage interest, they don’t require you to itemize your deductions. In other words, more people are eligible for the student loan interest deduction since itemizing won’t be too popular anymore. As you can see, the tax discussion gets complicated, so it’s wise to speak to a professional before deciding.
3. What other effects will your decision cause?
If you’re considering paying down a student loan, one rather specific effect you need to consider is whether the extra payments will jeopardize your chances of qualifying for student loan forgiveness. If you’re not already aware, certain individuals are eligible to have their student loans forgiven, depending on about 12,308 factors. The main factors are related to their profession, their student loan type, their income, and their repayment plan. But if you’re on a path to getting your loans forgiven, paying extra towards them might not be a great idea.
4. Are you on track to meet your goals?
Being a fee-only, holistic financial planning firm, we focus on our clients’ goals. The question of whether you’re on track to meet your goals might be the biggest reason to choose whether you pay down debt or invest. If you want to be able to afford to retire at age 65, but you’re way off track, it might be wise to crank up the amount you contribute to your investment accounts. If you’re overfunding your retirement by a long shot, maybe it’s not all that beneficial to save more. Or, maybe the thought of being in debt is just killing you, and you have a goal to be debt-free in three years. If that five-year car loan is keeping you up at night even though the interest rate is only 1.9%, perhaps it would be best for you to pay it off early.
5. How much can you tolerate risk?
This goes back to my first point, when I was comparing interest rates on a loan to the expected return in an investment account. A 3.125% interest rate compared to a 6.5% expected return isn’t really an apples-to-apples comparison. If you pay extra towards your loan, that interest expense savings is guaranteed. However, that 6.5% expected return is just that – expected, but not guaranteed. If you have a hard time with losses, which are very possible in an investment account, putting more in the markets as opposed to paying down debt might be challenging from a behavioral finance standpoint. Another scenario is if you’re comparing a 4.0% fixed interest rate with a 4.0% expected return with no tax effects. In that scenario, paying extra towards the debt is probably best, because they have the same “return”, but the loan doesn’t have risk. Here’s another caveat to that. When calculating which is best from a math standpoint, and you’re comparing those two 4.0% options, the loan only comes out ahead if you then invest after you’re done paying off the loan. If you pay extra towards your loan for three years, and then you spend that extra cash once the loan is paid off, that 4.0% interest savings didn’t amount to much. However, if you earn 4.0% on an investment for 20 years, that make a big difference.
As you can see, there is a lot to consider when deciding what to do with your extra cash. In reality, there is more to consider than what’s on this list, and there are more options for extra cash than just paying down debt or investing. And sometimes the best answer is: some of both! With that said, hopefully you feel like you have a better understanding of what is involved, and you feel empowered to decide.