One of the most popular questions regarding personal finance is what to do when you get a raise at work. Everyone likes being told they are getting a raise and seeing a couple extra bucks in your account every paycheck. This seems like a straightforward math question that shouldn’t be too hard to solve, however, there is emotion tied into it because we sometimes have a hard time looking at money without emotions.
This is a good reason to have yourself an investor policy outlining what happens when new money comes in. You have a few options and depending where you are in your journey, you will more than likely lean more heavily towards one option than the other.
Pay Off Your Debt
If you have debt, you should not be going out to treat yourself with a brand new Mercedes or going on an all-inclusive trip to Mexico. I hate to break it to you but until all your debt disappears, these should not be an option to you. I’m just trying to look out for you and help you get ahead instead of always playing from behind.
If you are already in your debt pay down process, there’s good news! You have just found a little extra every paycheck that you can use to further eliminate the debt. If you have $5,000 worth of debt with a minimum payment of $250 bi-weekly, it would normally take you 10 months to pay it off. Let’s say you now earn an $350 bi-weekly. By adding this money from your raise, in turn it will only take 7 months to pay of that debt.
You managed to save yourself 3 months of time. Now not only was your debt paid off in full earlier, but you now have $350 of income that was servicing debt now freed up that you can invest and start generating yourself more future income.
Increase Your Emergency Fund
Some debt already paid off? Perfect! Now there are a few more options at your disposal. Let’s start with the most basic option that we have. Why not save that money and build up your emergency fund if you don’t already have one? It’s definitely not the sexy choice but it does have the most calming affect for you as it will allow you to sleep better knowing that you have a healthy and sizeable emergency fund saved up. I like to have approximately 4 months’ worth of expenses saved. I’d also recommend keeping it liquid, making it readily available if you need cash fast.
The further down your journey and the more streams of income you have, the less reliant you will be on your emergency fund. Why? Because if you have other sources of income coming in (Side hustles, Cash Flow from rentals, Dividend payments, etc.) you will have other sources available to you to replenish it quickly or mitigate the need of a larger fund.
Increase Your Mortgage Payments
You have no debt other than your mortgage payments on your house? Why not try to cut that down as quickly as you can. Let’s say you have a house with $300,000 remaining on the mortgage for another 25 years at 2.14%. That monthly payment equates to roughly $1,291 that you are paying towards your principal on your house. That is also the base number required to service your mortgage. Now, if you add the extra money that you have from your raise on top of this, you will be able to accelerate your payments and chop off some time.
Topping up your payments will not only help you in the long run of making your mortgage disappear quicker, but when it comes time to refinance your house down the road and rates go back up (rates will not stay this low forever) you will have more wiggle room because you had already paid off a larger chunk as you were going. Now you will be able to stay closer to your base payment as rates go back up. On top of this, you will be paying less in interest at the same time as having paid off the house faster. This results in less money you are giving to the bank and more money in your pocket.
By increasing your mortgage by $200 a month you can save yourself $15,703 in interest. You also paid off your mortgage 4 years sooner, bringing your total amortization time down to 21 years.
Depending on your stage in life, there are some drawbacks to paying down your mortgage faster. If you are in the younger demographic, making the extra payments on your mortgage are nice because you are freeing yourself up quicker, however you could possibly be missing out on some larger returns in the market if you were to invest it (we will touch on that shortly). If you are in the older demographic, your house is probably your last remaining piece of debt keeping you tied to your job. Having this mortgage taken off your ledger will allow you to live completely debt free, with no major bills due.
Increase Your Investments
For some people that math is quite simple. Let’s say you save that that $100, invest it, and get an annual return of 8%. With a 2.14% mortgage (current rates at the writing of this post), the math would tell you that you have a greater advantage investing it and getting the net positive ~6% annual return rather then paying off the low interest debt.
Looking at it quickly, you will be hard pressed to find people who don’t believe the market will be higher in the next 25 years than it is today. The gap of 6% a year compounded over 25 years can quickly add up to a large sum of money. In this case, it adds up to just shy of $140,000 you would have on its own if it was invested. That’s a lot of money for just topping up your investments by the amount of your raise and letting that ride.
If you are tacking this extra $100 on top of our other investments, you are going to be accelerating your investment growth by consistently adding more money into the market for long term growth.
Here is the real kicker with this option: it really depends what your relationship is with money. For some people, the math tells them that it’s a better utilization of their money to invest it and get the surplus return, however, there is something magical about watching the amount that you have remaining on your mortgage get chipped away faster than expected.
This almost seems like a trivial issue that would be easy to decide between, but sometimes our emotions get in the way and block our judgement. It’s nice to have a guideline to fall back on that would help us figure out the best way to deploy our money. Both options have their own benefits that can help you further down the road.
What I Do
Personally, I do a little bit of both. I have my baseline lifestyle that I live at which is very similar to what it was when I started working. I take every raise I receive and I put it towards making extra payments towards my mortgage with the intention of using some of the equity in my property to purchase a rental property. I did this for 4 years prior to refinancing my property.
Now I still pay a little extra towards my mortgage because I like round numbers, but the rest of it has been shifted to going straight into investments. I find this an effective strategy because I’m putting my money to its highest and most effective use. If I were to let that money come into my account every paycheck I would easily find a way to spend it. Money without a job will find its way to spend itself every single time.
This is what I am comfortable doing because I understand the time-value of money and the faster that I deploy it in the market the better chance I have to make it grow faster in index funds. At the same time, I like putting that little bit extra down on my mortgage bi-weekly to see my mortgage shrink even a little quicker.