Ever notice a little extra money left over at the end of a pay period? Maybe you found ways to save on recurring expenses. Perhaps your practice is taking off or you earned a bonus. What if you find yourself the beneficiary of a sizable tax refund or inheritance?
If any of these situations occur, you have an important decision to make. In the interest in fiscal responsibility, ask yourself: What is the best way to use this extra money?
- Should you pay down student loans or credit card debt?
- Should you save it for a downpayment on a house?
- Should you invest it in the stock market or real estate?
- Should you allocate more to your retirement savings?
- Should you purchase disability or life insurance?
Ultimately, the choice is up to you and your needs. Regardless of the route you take, here are five factors to consider as you think about the best way to spend your extra money.
The first step is to assess is your financial wellbeing.
Do you have funds set aside for unforeseen expenses like emergencies and repairs? Having a savings account for these needs will prevent you from adding more high-interest debt to your credit card.
Can you handle your current obligations? Or do you find yourself piling more on to your credit card each month? If you’re overspending, consider using this extra cash to pay down debt. This will help you to fit your financial obligations within your regular income.
Do you have enough cash to pay off a debt like a credit card? If so, this could free up funds in your budget and accelerate the repayment of other debts.
Do you have an own-occupation disability insurance policy? What about term life insurance? Together, these will protect your income and your dependents against unexpected losses due to death or disability. Depending on your situation, consider using this extra money to boost your coverage.
Financial advisers typically suggest comparing:
- The interest rate you pay on your debt(s).
- The rate of return you would earn on savings or investments.
This will help you determine which option you will benefit most from.
For example, imagine your credit card debt is accumulating interest at 19 percent annually. Imagine investing would, at best, provide a 7-percent annual return. This means you could do better in the long run by retiring your credit card debt first. Of course, it all depends on your amount of debt versus the amount you are able to invest.
On the other hand, what if recently purchased a home? If so, chances are you’re paying a considerably low interest rate. Likewise, student loans, especially federally-backed loans, carry lower interest rates than most types of debt. In this case, repaying debt may not be as beneficial as investing.
Run the numbers on each of your repayment and investment options. Or better yet, work with a professional accountant or financial adviser to run them for you.
Most financial decisions have tax implications, both positive and negative.
For example, the interest you pay on student and mortgage loans is tax-deductible. That doesn’t mean you should carry as much debt as possible just to earn a tax break. Still, it's something to consider when deciding whether or not to accelerate payments on debt
Keep in mind that the more you contribute to a tax-deferred savings account like a 401(k) or IRA now, the less taxable income you need to report when filing taxes later.
Weigh your options with a reputable tax adviser to clearly understand the tax advantages and disadvantages of your financial decisions.
Be sure to consider your future goals when determining how to use extra funds.
Imagine you want to buy a house in the next year or so. If you can qualify for a physician mortgage loan, you probably will not need to make a downpayment. Better yet, any student debt you have will not disqualify you it would for a traditional mortgage.
This means you could pay down credit card debt to better fit a mortgage payment in your budget and reduce your debt-to-income ratio before applying for a mortgage. You may also want to set some cash aside for moving expenses, new appliances and other costs of homeownership.
Maybe you would like to open your own practice in a few years. If that’s the case, your retirement savings won’t help much with startup costs. However, having other savings available for a loan downpayment and/or repaying debts to better qualify for a loan would be beneficial.
All things considered, much of your decision may simply come down to personal preference.
If carrying debt bothers you, then use the extra money to pay down debt. This will give you greater control over how you spend your regular income.
The same goes for allocating it to your savings. If building up your savings now makes you feel more financially secure, then set your extra money aside and watch it grow.
This should go without saying. But we understand it's easy to get lost in the shuffle with so many different options at your disposal.
Whether you choose to accelerate debt repayment, save, or invest extra money, there really is no a bad choice. Sure, one may be better than another based on your personal situation. But as long as you dedicate your extra funds to actions that improve your overall finances, you will be better off in the long run.
The main thing to avoid is spending it on unneeded luxuries before reducing debt or saving for the future.
Because situations vary from person to person, it helps to consult a licensed financial adviser. He or she will help you understand the pros and cons of your options so you can make smart, swift decisions.
If you find yourself with a little extra dough, it's best to save, invest or pay down debt. In determining how to do so, be sure to consider your:
- Current financial situation.
- Interest rates and rates of return.
- Tax implications.
- Long-term financial goals.
- Personal preferences.
Ultimately, anything that improves your finances is a win. It's up to you to assess which route will be the most beneficial over time.
Joel Palmer is a writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.