836. 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.
836. 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.
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Hey everyone! This is Laura. I'm enjoying some time outside of the studio this week. But pull up a great bonus episode from the archive about a classic financial dilemma that Maya asks about investing extra money or sending it to a mortgage. I hope you enjoy it, and I'll be back with a new episode soon!
Hey Everyone! Welcome back to Finance Friday! It's another special edition of Money Girl, where I answer your burning money questions! Today's question is from Maya. She 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 the age of 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?"
Well, thank you for your awesome question, Maya, and congratulations to you and your husband for doing a such great job with your finances! I mean you're only in your mid-thirties, and you are well ahead of many other people your same age. And again a big virtual high five to you for doing that! This podcast will review how to prioritize any extra money you're fortunate enough to receive. Whether you get a raise, or its a cash gift or inheritance, or you win the lottery or maybe you just cut expenses out of your budget, that is a terrific opportunity to strengthen your financial security.
Again 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, you want to do that, so you never miss an episode! We're now doing two weekly shows that come out on Wednesdays and Fridays. Also, if you got a question you'd like me to cover on a Finance Friday Q&A show, I'd love to hear it! I want you to leave it on our voicemail line by calling 302-364-0308. And of course you can also send an email using my contact page at LauraDAdams.com. And while you're there, go ahead and sign up for The Money Stack. That's my newsletter that goes out 3 to 4 times a month. It's filled with all kind of financial tips, news, advice, my personal recommendations, and also invitations to live educational events. So I would love to see you on the list.
Alright let's talk about whether it's better to pay down a mortgage or invest when you have extra money. This is a common question, Maya. And while I'm a huge proponent of keeping low debt levels, there are times when investing is better for building wealth faster.
So before you make any significant decisions, I would love for you to just take a step back and think of your finances in a holistic view. of your finances and consider what you really want to accomplish with your money. Otherwise, you just aren't likely to make decisions that move you toward your financial goals.
For instance, you may want to throw an extravagant wedding, maybe you want to put your kids through college, start a business, or even purchase additional life insurance. Only you know the answers. So really think about what is my current financial situation, what are my goals, and how am I going to bridge that gap from where I am now to reaching my goals. And we're going to go through nine tips for using your extra cash wisely.
1. Boost your emergency savings.
When you're fortunate enough to have extra money, you want to 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! You know Maya maybe you want to review that. Just make sure that's still enough for you based on all of your family's goals.
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.
Creating a healthy, financial cash cushion should be your top financial priority if you don't already have one.
Check out Consumer Credit Union and Raisin for some of the highest interest rates on savings nationwide.
2. Review your insurance needs.
When you have extra money, review your insurance needs. So this is another essential way to prepare for the unexpected and prevent risks. You want to have various insurance policies, like health, life, disability, auto, 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.
So I recommend that Maya review her insurance and fill any coverage gaps with that 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 futures.
Even if you get life and disability coverage through work, I recommend you review it. It may not be enough to protect your family. Plus, remember if you leave your job for any reason, those policies typically end immediately or by the end of the same month. So you know having additional policies on your life or for disability can be a good idea, depending on what you're already getting at work.
3. Pay off dangerous debts.
So after you use any extra money to prepare for the unexpected with emergency money and insurance. Pay attention to any dangerous, expensive debts you may have. Now Maya said her mortgage is her only debt, which is fantastic! So she does not have any dangerous debts.
But if you have dangerous debts or if you have more debt than Maya, I recommend listing out your outstanding balances and their interest rates. Then, you want to sort that list from the highest to lowest interest rate, and in general, you want to tackle them in that order. But if you got dangerous debts, and these are things like overdue child support or overdue taxes that you haven't pay, you want to make those your top financial priority because they can really devastate your finances, if you don't get them caught up.
So let's say you got a credit card balance at 24% APR, a car loan at 10% APR, and a mortgage at 7% APR, you want to 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 your money on an after-tax basis. You'd be hard-pressed to find an investment yielding that much. So that's why paying off high rate debt is so important.
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.
Well, 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 Maya if you are claiming that deduction, it's likely netting you down to 6% interest or even less. So, prepaying lower-rate, tax-deductible debts—such as mortgages, home equity loans, and student loans—is typically not wise 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 as much wealth.
4. Maximize a workplace retirement account.
Maya mentioned investing enough in her workplace retirement account to get her employer matching. I want to 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. And 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 like me, you also have excellent retirement options. So don't forget! You could use a Simplified Employee Pension plan known as a SEP-IRA. That's the account I use. 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 love my SEP-IRA because it's easy to maintain with no annual paperwork. It's a really 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 a business partner) is a solo 401(k). However, you can only fund it through payroll deductions. So 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 that she max that 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. So Maya again I'm going to recommend that you really go for maxing out the workplace and use the Roth option if possible. And then if you can max that out and you still have more, you can max out the Roth IRA. Because you can do both. You can max out the Roth IRA and another retirement plan like a 401(k) or even a self-employed retirement plan in the same year.
Again I'd going to challenge you to use that Roth at work first, and then a Roth IRA annually. That's going to boost the tax-free income that you can 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).
Maya didn't mention having one, but this is another great way to invest extra cash, if you qualify. An HSA is one of my favorite accounts because it offers the most tax benefits. But you have to be enrolled in an HSA-eligible, high-deductible health plan to qualify. And you can get that coverage through a group health plan at work or buy it on your own as an individual.
For 2024, you can contribute up to $4,150 to an HSA if you got qualifying insurance for just yourself or up to $8,300 for a family insurance plan. Plus, if you're over age 55, you can contribute an additional $1,000 to an HSA.
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. And she may already be doing that, but she didn't mention it in her email. In addition to paying for college tuition, room and board, books, and computer equipment, recent 529 changes allow you to spend funds 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: 6 ways to save and invest money for kids
9. Invest in a brokerage.
Once you've got enough emergency money and the right insurance policies and 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.
Your tax rate depends on whether you owe short- or long-term capital gains and your tax bracket.
And if you want to learn more, you can listen to Money Girl episode 834, What Tax Will I Owe on My Investments?.
And Maya if you're still conflicted about investing extra money or using it to pay down a home loan, you can always do both. I'm recommending that you really lean more towards the investing side because a mortgage has such a low after-tax interest rate. You're going to get a lot more potential growth on that money if you invest it. But you can always do both. For instance, you could invest half that extra money and use half to pay down your mortgage. So I hope that's been helpful for you and everyone listening when you've got a little or a lot of extra money.
That's all for now. Remember to visit LauraDAdams.com
to send in your email or subscribe to The Money Stack newsletter. I'll talk to you soon. Until then, here's to living a richer life!
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