Laura answers a listener’s question about whether to invest extra money or use it to pay down a mortgage for the best long-term benefits.
Laura answers a listener’s question about whether to invest extra money or use it to pay down a mortgage for the best long-term benefits.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's question is from Maya, who says:
"Hi, Laura, I love the podcast! My husband and I are in our mid-thirties with a dual household income of $175,000 and two kids under three, which means a considerable daycare expense. Our mortgage balance is $120,000 at 7% interest, but we have no auto loans or credit card debt.
We have emergency money in high-yield savings for three to six months. I max out a Roth IRA annually and contribute enough to get my 401(k) match at work. My husband has a state-funded pension plan.
If we have extra money in our budget, should we invest it for mid-term goals and retirement or pay down our 7% mortgage, which I've heard some define as a high-rate debt?"
Thanks for your great question, Maya, and congratulations to you and your husband for doing a great job with your finances! This post will review how to prioritize any extra money you're fortunate to receive. Whether you get a raise, receive a cash gift or inheritance, or cut expenses, it's a terrific opportunity to strengthen your financial security.
Welcome back, everyone, and thanks for joining me. I'm Laura Adams, an author, personal finance influencer, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
If you're not already subscribed to the podcast, that's the best way to ensure you never miss an episode. There are now two weekly shows that come out on Wednesdays and Fridays. If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email using my contact page at LauraDAdams.com.
Is it better to invest or pay down a mortgage?
If you have extra money, a common question is whether to invest it or use it to pay down debt, including a mortgage. While I'm a huge proponent of keeping low debt levels, there are times when investing is better for building wealth faster.
Before making significant investing decisions, take a holistic view of your finances and consider what you want to accomplish with your precious resources. Otherwise, you aren't likely to make decisions that move you toward your financial goals.
For instance, you may want to throw an extravagant wedding, put your kids through college, start a business, or purchase additional life insurance. Only you know the answers. Based on your current financial situation and goals, here are nine tips for using your extra cash wisely.
1. Boost your emergency savings.
When you're fortunate enough to have extra money, cover the basics with a healthy emergency fund. How much you need depends on your income, expenses, debt payments, and goals. However, a good rule of thumb is to keep at least three to six months of living expenses on hand, which is what Maya has, so she's in great shape!
If accumulating that much seems out of reach, start with a small goal, like saving $500, then $1,000, until you have at least one month's worth of security, and build from there. Even a small cash reserve is better than nothing.
Saving, not investing, is the right move for reaching short-term goals, like maintaining emergency funds, taking a vacation, or buying a car in the next few years. While you won't earn as much compared to investing, you can rest easy knowing your cash will be there, plus interest, when needed.
Check out Consumer Credit Union and Raisin for some of the highest interest rates on savings nationwide. Creating a healthy cash cushion should be your top financial priority if you don't have one.
2. Review your insurance needs.
Another essential way to prepare for the unexpected and prevent risks is to have various insurance policies, such as health, life, disability, auto, and homeowners' or renters' policies. Being uninsured or underinsured means that a disaster, theft, or accident could wipe out everything you've worked hard for and jeopardize your financial future.
I recommend that Maya review her insurance and fill any coverage gaps with extra cash before prepaying a mortgage or investing. She mentioned having small children, which means she and her husband should have life insurance policies to protect their financial futures.
Even if you get life and disability coverage through work, it may not be enough to protect your family. Plus, if you leave your job for any reason, those policies typically end immediately or by the end of the same month.
3. Pay off dangerous debts.
After you use extra money to prepare for the unexpected, pay attention to any dangerous, expensive debts. Maya said her mortgage is her only debt, which is fantastic!
If you have more debt than Maya, I recommend listing your outstanding balances and interest rates. Then, sort the list from highest to lowest interest rate and tackle them in that order. But if you have any dangerous debts, like overdue child support or taxes, make those your top financial priority.
For instance, if you have a credit card balance at 24% APR, a car loan at 10% APR, and a mortgage at 7% APR, pay down the card first because it costs you the most interest on a percentage basis.
Paying off debt gives you a straightforward, guaranteed return. For instance, if you're carrying card debt charging 24%, paying it off is an immediate 24% return on an after-tax basis. You'd be hard-pressed to find an investment yielding that much.
However, there is less benefit for prepaying lower-rate, tax-deductible debt, such as a 6% or 7% mortgage. Maya mentioned hearing that debts at that rate are considered high-interest.
The fact is, if you claim the mortgage interest tax deduction on your taxes, it makes a home loan cost less on an after-tax basis, such as around 1% less. So, prepaying lower-rate, tax-deductible debts—such as mortgages, home equity loans, and student loans—is typically unwise because you could get higher returns by investing your money instead.
So, the trick to knowing if you should prepay debt or invest is carefully considering which option will likely give you the highest return over the long run. If you send extra money to relatively low-rate debt instead of investing for compounded returns, it could prevent you from building more wealth.
4. Maximize a workplace retirement account.
Maya mentioned investing enough in her workplace retirement account to get employer matching. I recommend that she put her retirement ahead of her creditors and increase her contributions to at least 10% to 15% of her gross income.
If you slowly increase your retirement contributions yearly, you'll max out the account before you know it. And if you do that consistently for decades, you'll likely have a multimillion-dollar account to spend in retirement!
For 2024, you can contribute up to $23,000 or $30,500 if you're over 50. That's in addition to any matching funds your employer may contribute on your behalf.
LISTEN ALSO: How much retirement savings you should have by age
5. Maximize a self-employed retirement account.
If you're self-employed, you also have excellent retirement options, such as a Simplified Employee Pension plan known as a SEP-IRA. It allows you to make tax-deductible contributions up to 20% of your net self-employment income.
For 2024, you can contribute up to $69,000 to a SEP-IRA. However, you can only contribute as much to a SEP-IRA as you earn.
I use a SEP-IRA because it's easy to maintain with no annual paperwork. It's an excellent option for business owners, with or without employees. You can contribute any amount (up to the limit) up to your tax filing deadline for the prior year.
Another great option when you have no full-time employees (except a spouse or business partner) is a solo 401(k). However, you can only fund it through payroll deductions. That means paying yourself a regular salary and calculating and submitting quarterly payroll taxes to the IRS.
ALSO READ: 4 ways to save for retirement when you're self-employed
6. Maximize a Roth individual retirement account (IRA).
Maya mentioned maxing out a Roth IRA annually, which is excellent. However, if her workplace retirement plan offers a Roth option, I suggest she max it out first because it has a much higher annual contribution limit.
As I mentioned, at Maya's age, she can put up to $23,000 in her workplace retirement plan for 2024. Her IRA contribution limit is just $7,000.
Plus, you can max out a Roth IRA and another retirement plan, such as a 401(k) or a self-employed retirement plan. I'd challenge Maya to max out her Roth at work first and then a Roth IRA annually, boosting the tax-free income she'll enjoy in retirement.
If you need help deciding whether to choose a traditional or Roth account, check out Empower's free retirement planner.
READ ALSO: How many retirement accounts can you have?
7. Maximize a health savings account (HSA).
Another great way to invest extra cash is maxing out an HSA, which is my favorite account because it offers the most tax benefits. However, you must be enrolled in an HSA-eligible, high-deductible health plan to qualify. You can purchase coverage through a group health plan at work or as an individual.
For 2024, you can contribute up to $4,150 to an HSA if you have qualifying insurance for yourself or up to $8,300 for a family plan. Plus, if you're over age 55, you can contribute an additional $1,000.
READ ALSO: Your guide to savings money with an HSA now and in retirement
8. Fund a 529 college savings plan.
Since Maya has young children, if she wants to pay their education expenses, I'd recommend using a 529 plan, like CollegeBacker, to start saving. In addition to paying for college tuition, room and board, books, and computer equipment, recent 529 changes allow you to spend it on younger children. You can use up to $10,000 per year for expenses for students in public or private kindergarten through high school.
While 529 contributions are not tax-deductible, your account's interest earnings and investment growth are never taxed if you use the funds for qualified expenses. And there are no restrictions on annual income to participate in a 529 plan.
READ ALSO: 5 ways to save and invest money for kids
9. Invest in a brokerage.
Once you've exhausted tax-advantaged ways to invest your extra money, it's time to consider investing through a taxable brokerage account, such as Betterment or Acorns.
Your tax rate depends on whether you owe short- or long-term capital gains and your tax bracket.
To learn more, listen to Money Girl episode 834, What Tax Will I Owe on My Investments?.
If you're still conflicted about investing extra money or using it to pay down a home loan, you can always do both. For instance, you could invest half and use half to pay down your mortgage.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast. It's audio-engineered by Steve Riekeberg. Our Director of Podcasts is Brannan Goetschius, our digital operations specialist is Holly Hutchings, our advertising operations specialist is Morgan Christianson, and our marketing and publicity associate is Davina Tomlin.