If you’ve budgeted correctly you should have extra money left from your paycheck each month. While it can feel like you’ve hit the jackpot and can go on a spending spree, that’s not the best use of your funds.
Instead, knowing how to use your extra money the smart way is important. You can make your money work for you, helping your net worth grow with just a few simple steps.
Are you not sure how to use your extra money? Here are the smartest uses of your funds.
Fund your Emergency Fund
Emergencies happen when we least expect it and when we’re the least prepared. Funding an emergency fund is the best way to prevent these issues from happening to you. If 2020 showed us anything, it’s that life can happen in the blink of an eye, and everything can change.
Instead of finding yourself caught unprepared, fund your emergency fund with any leftover money for the month and consider having a rainy day fund too.
What’s an Emergency Fund?
An emergency fund is a fund with 3 to 6 months of expenses in it. You should use it only if you lose your job or are unable to work. The fund should cover you for 3 to 6 months as you figure out your next step.
Common reasons to use an emergency fund are when you lose your job, fall ill, or get hurt and can’t work. It’s not a fund to use when you come up short one month because you overspent or even because of an unexpected expense. Save this money strictly for expenses.
What is a Rainy Day Fund?
A rainy day fund is a spinoff of the emergency fund. Instead of using it only when you lose your job or can’t work, you use it for unexpected expenses.
We’ve all been there. Your car breaks down in between paydays or your hot water heater breaks. You suddenly have this large expense to cover but don’t have the funds.
If you put any extra money you have each month into your rainy day fund, you can dig into the fund to pay for unexpected expenses like this. It’s best if you keep your rainy day fund separate from your regular checking account so you don’t spend the money when you shouldn’t.
How much money you should have in your rainy day fund varies. Think about your typical expense, like a home repair, medical bill, or car repair. Take that number times 5 – 6 and you have an idea of the minimum amount your rainy day fund should have. Honestly, though, you can’t have too much money in either account.
Pay off your Debt
If you have extra money each month, paying it toward your debt is a great use of it. Make sure you’ve contributed to your emergency fund and have enough money set aside in the event you lose your job, but then put all efforts into paying off your debt.
The extra money you have each month shouldn’t cover the minimum payment due – that should always be in your budget. Any extra money you have, though, should go toward one or more high interest consumer debts.
Here’s the easiest way to do it.
- Order your consumer debt in order of balance, smallest to largest, ignoring the interest rates
- Take the debt with the lowest balance and pay any extra money you have toward it first
- Repeat step 2 as often as necessary until you pay the first debt off in full
- Move onto the next debt in line when you pay off your first debt, using the same strategy
- Keep doing this until you’ve paid off all debt.
Why you Should Focus on Paying off your Debt
You might wonder why you’d put extra money toward your debt, giving you nothing to show for it.
There’s one reason.
You’ll save on interest.
The longer you have credit card balances, the more interest you’ll pay. Unless the interest rate is extremely low, you won’t be able to save more than you’d pay in interest. As long as you have an emergency fund set aside, your extra money is best used to pay off your credit card debt.
Save for your Child’s Education
If you have kids or think you’ll have kids, setting money aside for college now isn’t a bad idea. If you’ve set up your emergency fund and gotten yourself out of debt, saving for college is the next most logical step.
Saving for college now helps reduce the number of loans your child may need to take to attend college. Even if your child doesn’t go to college, you can help him/her start their adult life with financial ease.
You can save for your child’s education using a dedicated account, such as a 529 College Savings Plan, and get the tax deductions. You can even ask friends and family to contribute to the account rather than giving your child gifts during the holidays.
If you aren’t sure if your child will go to college, you can also set the money aside in a regular savings account, CD, or invest in a taxable account but have the money earmarked for a college education, you just won’t get the same tax benefits.
Save for a Down Payment on a Home
The more money you have to put down on a home, the easier it is to get approved for a mortgage. Whether you’re buying your first home, a subsequent home, or you want to invest in real estate, a down payment is crucial.
Ideally, you should have 20% or more to put down on a home. You’ll also have closing costs to pay, which can add up quickly since they cost 3% – 5% of your loan amount. The earlier you save for a home the more money you’ll have because you’ll give your money more time to grow.
Other Reasons to Save for a Home
Buying a home means a lot of financial responsibility. Sometimes it makes sense to keep some of your assets liquid to cover other expenses you might have with a home including:
- Home repairs
- Home renovations
- Furnishing your home
- Updating appliances
Pay your Mortgage off Early
If you already own a home, you can use any extra money you have at the end of the month to pay your mortgage off faster. Today, most mortgage loans don’t have a prepayment penalty today. This means you can pay your mortgage off early without paying a fine.
The good news is you don’t need a lot of money to pay your mortgage off early. Here are a few simple ways to pay it off with only a little extra money.
Pay an Extra Amount Each Month
Choose a small amount to add to your regular mortgage payment and pay it each month. It can be as little as $50 – $100 a month. It adds up quicker than you think.
Make an Extra Payment Each Year
If you come into extra money during certain times of the year, take money that’s equal to one monthly payment and pay it each year. You’ll make 13 payments each year, knocking your principal balance down and decreasing the interest you pay. You’ll also pay your loan off a few years early.
Make Lump Sum Payments
If you’d rather pay extra mortgage payments sporadically, just make an extra payment whenever you can. You’ll knock your principal balance down and pay less over the life of the loan.
Contribute to your Retirement
Even if you already contribute to your 401K, if you have extra money each month and you’ve funded your emergency fund and don’t have debt, invest in your future. You can make extra contributions to your 401K if you haven’t reached the annual maximum yet ($20,500 in 2022) or you can open an IRA and contribute to it.
The more money you save today, the more money you’ll have in retirement. Your money needs time to grow and the more time you give it, the more money you’ll have.
Using your extra money wisely each month will help you achieve your financial goals. Know where to use your money first so you pay the least amount of interest and make the most of your finances.