It probably doesn’t happen as much as you’d like, but from time to time, you have some extra disposable income. When this happens, how should you use the funds? Assuming you have adequate emergency savings — typically, three to six months’ worth of living expenses — should you pay off debts, or fund your IRA or another investment account?
There’s no one “correct” answer — and the priority of these options may change, depending on your financial goals. However, your first step may be to consider what type of debt you’re thinking of paying down with your extra money. For example, if you have a consumer loan that charges a high rate of interest — and you can’t deduct the interest payments from your taxes — you might conclude that it’s a good idea to get rid of this loan as quickly as possible.
Still, if the loan is relatively small, and the payments aren’t really impinging on your monthly cash flow that much, you might want to consider putting any extra money you have into an investment that has the potential to offer longer-term benefits. For instance, you might decide to fully fund your IRA for the year before tackling minor debts. (In 2014, you can contribute up to $5,500 to a traditional or Roth IRA, or $6,500 if you’re 50 or older.)
When it comes to making extra mortgage payments, however, the picture is more complicated. In the first place, mortgage interest is typically tax deductible, which makes your loan less “expensive.” Even beyond the issue of deductibility, you may instinctively feel that it’s best to whittle away your mortgage and build as much equity as possible in your home. But is that always a smart move?
Increasing your home equity is a goal of many homeowners — after all, the more equity you have in your home, the more cash you’ll get when you sell it. Yet, if your home’s value rises — which, admittedly, doesn’t always happen — you will still, in effect, be building equity without having to divert funds that could be placed elsewhere, such as in an investment. In this situation, it’s important to weigh your options. Do you want to lower your mortgage debts and possibly save on cumulative interest expenses? Or would you be better served to invest that money for potential growth or interest payments?
Here’s an additional consideration: If you tied up most of your money in home equity, you may well lose some flexibility and liquidity. If you were to fall ill or lose your job, could you get money out of your home if your emergency savings fund fell short? Possibly, in the form of a home equity line of credit or a second mortgage, but if you were not bringing in any income, a bank might not even approve such a loan — no matter how much equity you have in your house. You may more easily be able to sell stocks, bonds or other investment vehicles to gain access to needed cash.
Getting some extra money once in a while is a nice problem to have. Still, you won’t want to waste the opportunity — so, when choosing to pay down debts or put the money into investments, think carefully.
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