Windfalls of Cash
Extra Cash Options
At the end of this year, I will have paid off a small personal loan to which I have been making $100 monthly payments. When that loan is paid, I have several choices as to where to put that extra cash. I could put it into my savings/emergency account, where I am currently trying to save up three months' worth of income (I am about 44% there). Or I could use it as extra money to pay off my student loan (approximately $20,000 remaining at 5.875% fixed). Another option is to put it into my employee deferred compensation program for retirement, where I am currently contributing 5% of my gross income, pre-tax (I would like to be at 10%). Finally, I could use it as extra money towards my mortgage (approximately $40,000 remaining at 6.87% fixed). Which would be the best option?
Pay Off Smallest Debt First
I would pay the extra cash on your smallest debt, which appears to be your student loan from what is listed in the newsletter. You will see that one reduce rapidly with the extra $100 per month, and once that is paid off, you can roll the $100 plus your current student loan payment amount into your next debt, likely your mortgage. Once those are paid, you can really add a lot to your 401k! This is what I did and I'm debt free and spending a year "off" work with my son!
Three Step Approach
Congratulations for getting the loan off your plate. Now your issue is what to do with the extra cash. I think there may be several things to do:
- You suggest you are putting 5% of your earnings into your employer's deferred income plan. If your employer matches some portion of your contributions, increase your contribution up to the level that just gets you 100% of the available match and no more.
- Next, I would suggest you put the rest into your emergency fund. 44% of a three-month cushion does not seem sufficient. Further, I would raise the target to an amount that equals at least six months of living expenses. A nine-month cushion would be even better.
- Lastly, I would work off those student loans. With an interest rate of 5.875% fixed, this would be my last use of the money. Of course, more money would go to this expense once your emergency fund is fully funded.
Home is Largest Asset
If I am correct, your home is your largest asset (as for most people) so I would contribute the extra cash there. It will eventually shed years off your mortgage. Since you already contribute to a 401K plan, you already have an "emergency savings account" because most 401Ks allow you to withdraw money in case of financial hardship (taxes may apply). And although it is wise to want to pay off your student loan first, it is an unsecured loan so your best option is to pay off your largest asset first and pay off the student loan as you have.
Use the 60/40 Principle
One of the best ways to keep money flowing in our lives is to follow the Money Cycle. Money flows by a system of expenses, savings, and giving. If you put extra cash into all these areas, you will get more back into your life. This cycle is regenerative.
I teach my clients to use the 60/40 principle when it comes to extra cash in their life. Put 60% in your checking account to pay off whatever loan you feel is most important. Then take 10% and put it into the emergency fund you have for that three months of salary you're working toward. 10% then goes into your retirement fund and then 10% goes to a charity of your choice along with 10% to your religious affiliation. If you don't have a spiritual organization that you belong, then put 20% of the money toward charitable giving.
The point is this, 60% of your money will be for living expenses (loans, etc.), 20% will be put into various savings categories, and 20% will be given away. By using these ratios, you will move toward a stronger financial situation in very short order. Do this every month and you'll be amazed at how your financial life changes.
editor's note: Janine Bolon is the Founder of SmartCents, Inc. Ms. Bolon has been a contributor to The Dollar Stretcher. You can find her articles by visiting the Author's Index on Stretcher.com.
Depends On Your Specific Goals
Congratulations on getting rid of your debt! What you do with that $100 really depends on your age, your goals, and what you're comfortable with. Are you getting a jump on saving for retirement, or trying to make up for lost time? Are you dying to be rid of your school loans? Do you hope to pay your mortgage off early? Are you at risk of a layoff or other crisis that would swallow your emergency fund?
Applying your money to anything on this list is a good idea, but putting it toward the mortgage would probably save you the most in interest over time. Another great thing is that you can program an automatic payment or transfer for any of the things you mentioned, which will help keep you on track.
Alicia in Chicago
Get Full Employer's Match
If the reader choose to contribute to her company's 401(k) plan, she should make sure she contributes enough to get her employer's match contribution. That is "free" money to her and she should take advantage of it. I am an auditor of various Company's 401(k) plans and it is amazing how many people do not take advantage of it.
Emergency Fund First
I've been in a similar situation myself. And in the end, I think the best option is to simply invest the extra cash into the emergency fund (and probably put it in a high-interest savings account for easy accessibility).
Ultimately, I chose that option for myself because the interest for both my mortgage and student loans was tax-deductible. That's no small factor to consider. Investing in the retirement account was also a big consideration. However, I came to the conclusion that the money in my retirement account was a poor option in the case of an emergency and that I would be eventually forcing myself to either risk my retirement money or use my credit cards to cover emergency expenses. After all, it's inevitable that the day will come when I'd need emergency funds.
Besides, my high-interest savings account has been earning almost as high an interest rate as the rate of return on my retirement fund investments in recent years.
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