When you have extra money, you may want to put it toward paying down your debts. While reducing your debt does improve your financial health, in some cases the money could be used to boost your long-term finances in a different way.
Learn how to prioritize debt and about alternate ways in which you can spend your excess cash.
- If you have several loans or debts to repay, determine which ones to pay off first.
- Try to prioritize high-interest debts as well as those that will most impact your credit score negatively if you fall behind.
- Some people aim to pay the lowest amount of debt first to stay motivated as they eliminate a debt faster.
- Debts with very low interest rates may be better paying off according to the loan terms and using extra money toward investing.
Credit Card Debt
The best strategy for credit card balances is to get rid of them as quickly as you can because credit card debt typically carries a high interest rate. When you carry credit card debt, that debt can compound quickly and create a debt spiral.
Eliminating credit card debt will likely also improve your credit score. About a third of your all-important FICO score is tied to how much you owe creditors—and revolving credit card balances are weighted against you even more than other types of debt.
By lowering your “credit utilization ratio”—how much you owe in relation to your available credit—you can boost your score and improve your chances of getting the loans you truly need. A good rule of thumb is to borrow no more than 30% of your total credit line. If you have a significant amount of debt that falls into this category, you may need to consider debt relief options.
If you have multiple credit card accounts, you need to determine which one to pay down first. Some people use the avalanche method, which is paying down the cards with the highest interest rates first. This method saves you the most money.
With the snowball method, you pay down the smallest debt first, This method is useful for some people who find it more motivating.
Debts to Pay Down Later
Most financial experts agree that student loans and mortgages are debts that should have lower priority than credit cards. These loans are typically inexpensive compared to other forms of debt. The rates are even cheaper when you consider that interest on both of these loans is often tax-deductible.
Let’s assume that you have a 30-year mortgage with a fixed interest rate of 4% on the loan. Even if you don’t have any other loans with a higher interest rate, you might not want to pay more than the minimum amount due each month. That's because you could potentially earn more by investing it. Economists refer to this as an "opportunity cost." Over time, the market has shown a tendency to return well over 4% during the long haul.
Tax-Advantaged Retirement Accounts
If you’re putting your spare money into tax-advantaged retirement accounts such as a 401(k) or a traditional IRA, you can deduct your contributions to these accounts from your taxable income. so when you invest more into these accounts you get a tax benefit.
In contrast, when you accelerate student loan and mortgage payments, you’re using post-tax dollars to reduce tax-deductible interest. So while you may be glad to get rid of these loans, it often is not the best choice for your long-term finances.
While paying down high-interest-rate loans is an important goal, it shouldn’t necessarily be your first priority. Many financial planners suggest prioritizing the creation of an emergency fund that can cover between three to six months’ worth of expenses.
It’s also wise to avoid pre-paying your loans at the expense of a retirement account. Except for specific circumstances, taking funds from your 401(k) early will trigger a costly 10% penalty on the entire withdrawal.
Forgoing contributions to your employer’s retirement plan can mean losing out on "free money" if your employer offers a matching contribution. Consider first contributing enough to tap all the matching funds available before you pay more than the monthly minimum payment on your debts.
Many financial planners suggest prioritizing the creation of an emergency fund that can cover between three to six months’ worth of expenses.
Is the Snowball or Avalanche Method Better?
Whether the snowball or avalanche method is better will depend on your personal circumstances. The avalanche method, which is paying off debts with the highest interest rate first, will save you more money in the long run. However, some people are more successful with the snowball method, which starts with putting extra money toward your smallest debts first.
How Much Money Should be in an Emergency Fund?
The exact amount of money that should be in an emergency fund will depend on your personal circumstance, but many professional advisors recommend keeping at least three to six months' worth of necessary expenses on hand.
Should You Use Your 401(k) Money to Payoff Debt?
Withdrawing funds from your 401(k) will typically entail early withdrawal fees. Depending on whether your investments have gained in value, you may have a substantial tax bill on the withdrawals as well. When you withdraw money from your retirement account, you will also not get the benefit of compounding interest. Weigh all these factors against the benefits of paying off your debt.
The Bottom Line
There are certain types of debt that you should eradicate as soon as you can (except at the expense of employer matches to tax-advantaged retirement accounts). But with low-interest rate loans, including student loans and mortgages, you’re normally better off diverting extra cash into a tax-advantaged investment account.
If you have enough left over to max out your allowable annual contributions for an IRA and 401(k), any extra cash beyond that amount should go into a regular investment account rather than toward paying off low-interest loans. You'll net more money in the end.