I’m (Mostly) Debt Free. What Do I Do with My Extra Cash?

 A "debt free" Lady Liberty? (er...not really)

A "debt free" Lady Liberty? (er...not really)

A friend recently asked (paraphrased slightly),

“My husband and I have paid off our student loans and car loans. This has been done over a 5 year period. We are now in a position where we have some extra income. The only debt we have is our mortgage. We have a good nest egg of savings for emergency. If we go at the rate of paying off debt as we have over the past 5 years, we could pay off our house within 4 years. Should we hurry and pay off the house, or invest our money in other places?”

If you’re lucky enough to find yourself in this situation, it probably means you have a good paying job, you live frugally, or some combination of the two. I hope this couple is proud of themselves! Any effort to attack debt so aggressively should be celebrated.

Understand Your Financial Priorities

Any decision of “What do I do next with my money?” should start with a discussion with one’s spouse of your financial priorities. What are your financial goals for the next 5, 10, and 20 years?

  • Would you like to retire? What does retirement look like to you?

  • Do you have children? Would you like to save for their schooling needs or other financial needs they’ll have when money is harder to come by?
  • Have you finished your own schooling, or is there more education in your future? (Editor’s note: Four months ago I enrolled in an online course to earn my CFP credentials. I’m 36! Never stop learning!)

My clients have expressed other goals such as:

  • Pay cash for a new vehicle in 5 years
  • Purchase a plot of land in 8 years for a future family ranch
  • Start a small business in 15 years

Virtually any future purchase or state of living can be tied to a financial goal and planned around. So start by dreaming of what your future life could look like, and then make a plan to set aside some money toward those goals.

Before addressing other financial goals, however, there are three essential areas that my friend should be sure to take care of first.

Protect Your Family

If this couple hasn’t done so already, they should make sure they have sufficient insurance coverage to protect their family should something occur to the primary income source(s). If this hasn’t been done already, then it should be priority #1. This typically means purchasing a life insurance policy on the husband, wife, or both depending on your family needs and financial situation.

You can determine how much life insurance you’ll need by combining your current wages and multiply them by 20. Then purchase a term life insurance policy to last until your planned retirement age. For example:

$80,000.00 (Wages)
x 20 (Multiplier)
=$1,600,000.00

This is a very simple approach and your situation may require different coverage amounts or insurance types, but I’d encourage you to not overthink it. Postponing the purchase of this essential financial product leaves your family vulnerable. Your family still needs a roof over their heads and food on their plates if the primary bread winner is not around. Do them a favor by purchasing life insurance.

Is Your Emergency Savings Enough?

In addition to paying off their debts, this couple has wisely built an emergency savings fund. Before moving on to allocating their extra cash elsewhere, they should make sure they have sufficient emergency savings. Doing a rough calculation of your essential monthly expenses is a good start. Leave the non-essentials out the calculation, since you probably won’t be frequenting restaurants or bowling alleys (if you’re into that sort of thing) in a financial emergency (typically the loss of a job.)

Next do an assessment of how many months worth of savings you’ll need in this fund  and set aside some extra emergency savings if needed.

What About Retirement?

The biggest opportunity I see is that the only mention of savings is the emergency fund. If this couple hasn’t started saving for retirement through a tax-advantaged investment account, like at IRA or 401(k) plan, they should start immediately. The benefits of a 401(k), such as an employer match, $18,000 contribution limits (as of 2016), and pre-tax contributions, are too great to pass up. 401(k)s are one of the best tools available for working toward long-term savings goals, like retirement or financial independence.

If a 401(k) is not available, the couple could open a Traditional IRA or Roth IRA (income restrictions apply.) These don’t have an employer match, since they’re individually owned, but they have tax-advantaged contributions and tax-free growth.

Paying off a Mortgage Early

I don’t know much about this couple’s financial situation, but seeing their relentless attack on paying down debts, I suspect their discretionary spending isn’t out of control. With only their mortgage remaining, is this the next logical place to direct their excess cash flow once they’ve addressed the previous points?

My wife and I found ourselves in this same situation. For several years we were both working full-time and had a lot of extra income. We had a $180,000 mortgage with a reasonable monthly payment and an excellent interest rate. Many people say that paying down a mortgage is unwise, especially with a relatively low interest rate. “Why not invest it in the stock market or another asset where your money can grow at a HIGHER rate compared to the interest you’re paying?” This is a very common refrain, and as an MBA and financial planner I certainly understand the economic logic.

However, debt is debt. Some folks squirm at the sight of it while others see opportunity. I criticize neither group. If you’re the squirming type, I’d suggest at least making an extra payment a few times a year. This will give you incredible peace of mind as your mortgage term can be significantly decreased with even a few extra payments. If you’d prefer to ride out your mortgage to the full term and invest the excess elsewhere, then go for it.

My wife and I decided, after a lot of thought and discussion, to pay down our mortgage as quickly as possible. After about a year of saving we refinanced to a 15-year fixed loan along with a large accompanying additional payment. Could the money have gone into the stock market or college savings? Sure, but paying it down felt better to us.

In Summary

I hope this is helpful to anyone who finds themselves mostly debt free. First, make an assessment of whether your financial essentials are taken care of, like life insurance and emergency savings. Once these are resolved, target your retirement or long-term savings through a tax-advantaged account. At the same time, discuss with your spouse your other financial priorities. If you still feel like paying off your mortgage early is an important goal for your family, then start chopping away at it and become truly debt free.