It doesn’t happen as much as you’d like, but sometimes you have extra disposable income. When this happens, how should you use the funds? Assuming you have adequate emergency savings — three to six months’ worth of living expenses — should you pay off debts, or fund your IRA or another investment account?
There’s no “correct” answer — and the priority may change, depending on your financial goals. Your first step is to consider what type of debt you’re thinking of paying down with your extra money. If you have a loan that charges a high rate of interest — and can’t deduct the interest payments from your taxes — you might decide it’s a good idea to get rid of this loan.
If the loan is small, and the payments aren’t impinging on your monthly cash flow much, you might consider putting extra money you have into an investment that has the potential to offer longer-term benefits. 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 the picture is more complicated. In the first place, mortgage interest is typically tax deductible, making your loan less “expensive.” Beyond the issue of deductibility, you may 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 — the more equity you have in your home, the more cash you’ll get when you sell it. If your home’s value rises — which doesn’t always happen — you will still be building equity without having to divert funds that could be placed elsewhere, like in an investment. It’s important to weigh your options. Do you want to lower your mortgage debts and possibly save on interest expenses? Or would you be better served investing 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 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, with a home equity line of credit or a second mortgage, but if you weren’t bringing in income, a bank might not even approve such a loan — no matter how much equity you have in your house. You could easily sell stocks, bonds or other investments to gain access to needed cash.
Getting extra money once in a while is a nice problem to have. You won’t want to waste the opportunity. So, when choosing to pay down debts or put the money into investments, think carefully.
This article was written by Edward Jones for use by your local Edward Jones Financial Advisor.
Information provided by Karl Ritland, Edward Jones, 1100 N. Hickory Blvd., Suite 201, Pleasant Hill, 266-8188, www.edwardjones.com.