Deciding how to effectively use your extra income isn’t as simple as you think.
We all have bills and expenses like rent and groceries that we must cover each month. That’s just a part of life. But what do you do with your next dollar after taking care of the necessities?
Assuming you don’t just spend it, your choices can often be bucketed into two priorities: saving for the future or paying down debt. The consequence of these needs isn’t small either.
The truth is over 45 million American borrowers hold over $1.7 trillion in student loans,1 and 37% of people can’t pay a $400 unexpected expense.2 Combine that with a U.S. retirement savings shortfall projected to reach $137 trillion by 20503 and the answer of what to do with your next dollar is far less clear.
Set yourself up for success first
Before you can start taking steps to achieve your financial goals, it’s crucial to prepare for the unexpected. An emergency fund is a strong foundation that can keep you on course when some of life’s unexpected realities happen.
Identifying possibilities like a sudden job loss or home repairs before they arise can help you decide how much to keep in your emergency fund. In general, you should consider having at least two to three months of necessary living expenses on hand.
Remember that unexpected expenses are likely to arise. Keeping cash on hand can prevent you from accruing expensive debt like credit card balances that compound against your future goals. By addressing your current financial stability first, it may then be possible to confidently allocate extra income to your future.
When to save for the future
There are important trade-offs to consider between saving or reducing debt. Yet the best move you can make is to start saving right away, even if it’s just a modest amount. Doing so allows you to take advantage of compounded savings, tax incentives and matching contributions.
When you’re young, time is on your side. This makes saving an important consideration. Giving your money the opportunity to grow and compound is key towards building a comfortable retirement.
Further, making extra payments on debt rather than saving may not make sense in some situations. That can be especially true if you’re not taking advantage of the “free money” contributed as part of your company’s retirement match. Leaving those dollars on the table can reduce the full potential of your retirement savings.
As a rule of thumb, consider focusing on earning the maximum benefit from tax-advantaged savings tools like Health Savings Accounts and retirement contributions first. After that you can devote extra dollars to tackling high interest and non-deductible debt.
When to pay off debt
That’s not to dismiss the impact of paying off debt sooner. Monthly interest can eat away at your future income, compounding in the opposite direction as your savings.
Once you’ve maximized savings, be strategic when allocating your extra income to repay debt at a faster rate. Consider prioritizing your most expensive and highest interest credit accounts.
In this sense, not all debt is created equal. Having a mortgage doesn’t hold the same consequence as carrying a balance on a credit card account. Paying down the latter first can lessen your exposure to high-interest debt and may open additional resources in an emergency.
Is it possible to make this equation easier?
Companies are exploring new ways to encourage their employees to both pay off debt and pursue their retirement goals, including benefits created by a recent IRS ruling that allows student loan payments to receive matching retirement contributions.
Technology will play an important role as well. Several tools already exist to help people develop a holistic picture of their financial situation. In the future, we could leverage powerful analytics to intelligently decide how to use income appropriately based on a wide range of factors.
Until then, it’s important to find a balance between future needs and present priorities. Saving isn’t all or nothing, and taking smart approaches to saving today while still managing debt will only benefit you in the long run.
