If you find yourself with some extra money – let’s say you got a big tax refund, or received a nice inheritance – then you’ll need to decide what to do with it. If you have a mortgage worth hundreds of thousands of dollars, it may be tempting to put your windfall toward making extra payments, so you can eliminate interest-earning debt. On the other hand, it may be wise to invest it; any financial advisor will tell you that investing is arguably the best way to build wealth over the long term. If you’re faced with this decision, we’ll walk you through making the best decision for your money.
3 Things to Do Before Paying Down Your Mortgage or Investing
There are arguments for both paying down your mortgage and investing more. Before you do either, though, there are a few other moves you should make first.
1. Pay Down High-Interest Debt
For most people, high interest debt means credit card debt. Other revolving lines of credit may also have high interest rates. If you have any short-term loans, such as payday loans, pay down those balances as soon as possible.
The interest rate on these debts makes the math simple. You will almost certainly save more in the long run by paying these high-interest debts before making extra payments on a mortgage. Consider that the average interest rate on a mortgage is about 5%. The average return from the stock market is about 7%. Meanwhile, the average interest rate for a credit card is between 15% and 20%. Because your credit card interest will increase much faster than either your mortgage interest or your stock market gains, your money will go farthest if you take care of that first.
If you have a lot of credit card debt to pay off, consider a balance transfer card (especially if you have interest on multiple cards). Balance transfer cards often come with an introductory period of 0% interest. That effectively puts a temporary pause on the growth of your credit-card debt.
2. Build emergency savings.
According to a 2017 survey by CareerBuilder, 78% of Americans live paycheck to paycheck. Even 9% of people with incomes of $100,000 or more live paycheck to paycheck. If you don’t have any savings, you can find yourself in a very difficult position should something unexpected happen. That’s why it’s a good idea to build some emergency savings. Most experts will recommend a liquid, safe emergency fund covering 3-6 months of living expenses. The best savings accounts can even give you some decent interest on your fund without exposing it to market risk.
After you’ve paid down any high-interest debt, you should start an emergency fund (or make sure any existing fund is properly funded). If that still doesn’t get you to 3-6 months of expenses, set up a plan to start contributing regularly. Our simple guide to making a budget can help you find room in your budget for these regular contributions.
As you start investing more or making extra mortgage payments, remember to maintain this savings fund. If you don’t always have a liquid fund that you can access at any time, you’re exposing yourself to risk. And as your situation changes, you will need to adjust your savings. For example, you should increase how much savings you have on hand as you have kids (or even pets). So if you don’t have enough in savings, forgo investing and extra payments in favor of growing your savings.
3. Max Out Your 401(k)s Employer Match
Many employers offer some degree of matching on their 401(k) plans. This matching is effectively free money, you should contribute at least enough to meet that employer match. If you’re currently falling short of getting the maximum possible matching amount – perhaps because money has been too tight to defer too much of your paycheck – then it’s time to make it happen. See if you can take advantage of your extra wealth in a way that allows you to up your contribution and get that free money.
Once you’ve taken care of these three priorities, you can address either your mortgage or your investments. Here’s when each option makes the most sense.