As we enter a new month, you may find yourself with disposable income. This is a great problem to have! But what should you do with this extra income on a monthly basis? Should you save it? Should you pay down debt? Should you throw more money toward your retirement savings? What about the shorter-term goals you have?
In this article, we’ll unpack a variety of financial strategies to help clarify what might be the best solution for you.
An emergency fund is a sum of money that you don’t tap into unless something drastic happens, like the loss of a job or an unforeseen, catastrophic expense. The rule of thumb is to have three to six months’ worth of living expenses saved in your emergency fund.
You can think of this as your “sleep better at night” fund; it provides a cushion of protection that will help you feel more confident about your financial situation no matter what the future might bring.
Typically, emergency funds are housed in bank savings accounts where you can access the funds quickly and without market risk. Since savings accounts usually do not provide much in the way of interest, though, we’d recommend considering other strategies once your emergency fund is full.
Backup Emergency Fund
With three to six months’ worth of living expenses squirreled away, and less weight on your shoulders about basic needs like food and shelter, you may find yourself daydreaming about financial goals that you’d like to chip away at—a new purchase, perhaps, or a big trip.
It might be time to create a backup emergency fund. These are typically earmarked for specific goals or uses, but they could in theory be used in an emergency as well—like an additional layer of financial protection.
Backup emergency funds can be separated into two categories based on the time frame surrounding for your goals.
Are you hoping to buy a car, upgrade your kitchen appliances, or start a big backyard project within the next one to three years? Opening a second savings account designated for your specific dreams will help keep you accountable to reach your goal. If housed on its own, your progress toward your goal can easily be checked simply by looking at the value. You may find this ability speeds up your rate of saving!
If your plan for the funds is on the outer end of this time frame—say, two to three years—you might find it worthwhile to research high-yield savings accounts.
These earn a higher interest rate than traditional savings accounts because they are offered through online banking companies, which aren’t bound to brick-and-mortar locations and therefore have lower overhead costs.
As of this writing, American Express and Ally Bank offer high-yield savings accounts worth considering.
Larger purchases, such as a down payment on a vacation home, might require more time to save. If the time horizon for your larger goal is between three and 10 years, it would be worth asking your financial planner whether taking on more risk to achieve you goals makes sense for your personal scenario.
If it does, your planner may recommend investing your monthly savings into an individual or joint brokerage account where your rate of return is higher than interest earned in a savings account. Although the growth in the account is taxable, the money can be taken out prior to retirement and used without penalty.
Are you still working? Boosting your retirement saving efforts—no matter how young or old you are—is always a good idea. There is perhaps more incentive for younger individuals, though, since the power of compound interest has a greater effect the longer you have until retirement.
When it comes to retirement savings, being flexible and having options are important. Despite the best planning efforts, external factors, such as company downsizing, market dips, or an unexpected health crisis, could impact your retirement date.
Therefore, having ample savings—and perhaps even multiple retirement savings account types (i.e., a 401(k) and a Roth IRA)—will make you more prepared for whatever curveball life throws at you.
Paying Off Debt
Are you still paying down a large car loan or student loan? Or are you trying to pay off your mortgage before retirement?
Paying off your debt and eliminating that monthly line item in your budget has a two-fold benefit. First, it gives you more excess money to redirect toward your other financial goals, meaning you can reach those goals faster.
Second, it decreases your overall living expenses which gives your financial plan a great deal more flexibility. If you have multiple credit lines that you are paying down, a mortgage refinance could be another tool in the toolbox that helps you achieve you financial goals most efficiently.
In many cases, a combination of these strategies is the best use of extra income. Let’s say, for example, that you have put all your disposable income toward your mortgage (to pay off debt) but neglected to build an emergency fund. If you lost your job, you’d actually have more risk to lose your house since you wouldn’t have income or savings to draw from for your mortgage payment.
A more common example of this combination strategy is the decision to either save for retirement or pay down the mortgage. Many of our clients ultimately decide to work toward both goals at the same time instead of focusing on just one, and we’ve seen it work out well time and again.
Prioritizing the two or three most critical goals for your situation and chipping away at them concurrently typically adds strength and durability to your financial plan. Once you meet a goal, you can simply redirect that disposable income to your midlevel goals.
Everyone’s financial situation is different, so there is no one-size-fits-all solution for disposable income. However, by considering the various strategies presented in this article, you’ll be able to prioritize which goals are most important to you and would make the biggest impact to your financial plan.
It is likely that a combination of these strategies will make the most sense and that over time, you’ll have the opportunity to put all these strategies to work.