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Articles - Money Management
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Back to Money Management view printable version 
Deciding How To Allocate Additional Funds
Determining what to do with additional funds can be a complicated issue, especially for those in debt. In order to help you decide which is best for your situation, we have listed a few of the options available to you, along with the advantages and disadvantages of each.
Strategy #1: Using excess funds to pay down credit card balances.
Advantages
Paying down credit card balances usually results in paying back less interest to creditors. The savings in interest may, in fact, be much greater than the actual sum of the additional funds. You can plug numbers into the account details to estimate how much you could save.
Paying down credit card balances may also help you pay off the debt in an accelerated timeframe. When you make an additional payment to creditors, you reduce the amount of debt that you will be charged interest on for all remaining months, thereby speeding up the payoff process. Furthermore, it is more beneficial to pay $50 extra on an account today, than it will be to pay $50 extra 3 months from now. The sooner your debts are paid off, the sooner you can put future income streams to use earning interest rather than paying back interest.
Moreover, reducing your outstanding debt load often improves your credit score. Thirty percent of your credit score is determined by your level of outstanding debt. This is often referred to as utilization. If you had a combined credit limit of $10,000 and still owed $9,000 you would be 90% utilized. So any time you pay down your debt, you become less utilized and that reflects positively in your credit score.
Generally, you will also receive a return on your money equal to the interest rate being charged by the lender. For instance, suppose one of your cards has an APR of 21 percent, when you apply additional funds to this creditor you are essentially getting a return of 21 percent.
Finally, this strategy may allow you to pay off a smaller account completely and provide greater flexibility in the future. For example, we will start sending the monthly payment from the creditor that is paid in full to the creditor with the highest interest rate. So, if a situation arises in the future where this new monthly payment needs to be adjusted, there will be some flexibility.
Disadvantages
If an emergency arises and no funds have been set aside to help cover the unexpected expense or lack of income, you will probably fall behind on your bills. This is because creditors generally do not consider the increased payment amounts as prepayment and require at least the minimum payment each month. So missing future payments may:
- Have a negative impact on your credit report.
- Result in fees from lenders.
- Lengthen the repayment timeframe.
- Result in some creditors refusing re-entry into a DMP.
You will not be eligible for investments returns that may have been available by investing your additional funds rather than paying down your credit card balances. With investments, you may be able to get 100% return on money if you are contributing to a 401(k) or other investment vehicle in which an employer matches the contribution. One exception might be if you have already contributed more than the amount the employer matches. Another consideration is how vested you are and/or if you plan to be with the company long enough to be vested. Finally, there is generally no guarantee what will happen when the money is invested, so the 100% automatic return may not be realized.
In addition, you may be giving up tax advantages that might come from using the money to contribute to an education account, 401(k), IRAs, etc.
Strategy #2: Using excess funds to establish an emergency fund.
Advantages
Emergency expenses can be paid without having to repay them at high interest rates. For example, do you really want to pay interest on a new tire if your old tire blows? Or imagine having to pay interest on groceries you purchased while you were out of work?
An emergency fund will allow you to keep current on your bills if you were to lose your job. This would help you avoid:
- Missed mortgage or rent payments that may result in foreclosure/eviction
- Late fees
- Damaging marks on your credit report
If the emergency is job loss, the fund will provide additional time to secure employment with the salary/wages you need. If you live paycheck to paycheck, you might have to take the first job you can get to keep food on the table.
You should be able to earn at least some interest on the money in your emergency fund. Finally, knowing that you are financially prepared for emergencies brings peace of mind which, for many, is also an important consideration.
Disadvantages
Money in an emergency fund will need to be easily accessible, which means that it will probably be earning interest at a low rate.
Putting money aside on your own is generally not an easy task. You will need to be disciplined to not use the funds to finance additional purchases.
While an emergency fund helps prepare for future events, current debt already exists and is a sure thing. You may not lose your job in the next few years or experience a significant financial emergency, so paying down current debt might be more beneficial.
Read more about creating an emergency fund.
Strategy #3: Using excess funds to contribute to an investment vehicle.
Advantages
Your employer may match contribution amounts up to a certain percentage of income. If you have not reached that limit you may be able to receive an immediate 100% return on your contribution.
You may take advantage of the additional tax benefits that are usually associated with educational investments and retirement investments.
The money in these types of accounts may be protected in a bankruptcy. If your financial situation is getting worse and not expected to improve, you may want to consider putting money into these types of accounts. We suggest that you discuss this option with a lawyer if you feel you fall into this category.
Disadvantages
Foremost, many investments do not have a guaranteed return and there is a degree of risk.
The funds in these types of investment vehicles are usually not readily accessible, which may cause complications in the case of an emergency. If you were to have such an emergency and needed access to these funds, you would probably have to pay substantial penalties.
For more information and advice, explore this option with your employer, tax advisor or financial advisor.
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