It’s called personal finance for a reason. While there are rules that you can follow, our emotions and personal preferences enter the picture often. As a new parent, it can be challenging to think of longer-term goals versus providing for your young children right now. Dealing with this balance between listening to your gut and developing financial processes is a significant transformation that we all go through as we leave the period of carefree leisure and enter the time when we start or continue to grow our family. Nowhere is this more pertinent than in the discussion of deciding what to do with our extra monthly cash flow.
After working with your expenses over the past few months, you now have a reasonably good idea of those numbers. Let’s assume you are cash flow positive. What to do with that extra money you are generating every month? I suggest three options.
Build your cash cushion.
Pay down debt.
Build up equity.
Build a Cash Cushion
A cash cushion is the amount of money that is in your checking account for emergency reasons. This number is a combination of financial calculations and emotion.
Financially, you can determine your cash cushion amount by multiplying your monthly expenses by 2x or 3x. This method will give you a chunk of cash that you use only if an unexpected situation develops.
But there is an emotional component to this calculation! We all want a certain amount of money in our checking account to feel more financially stable.
The final amount of the cash cushion is a combination of the two methodologies. If you have this amount in your account, you can move on to the subsequent discussion around paying down debt faster.
Pay Down Debt
Debt is another emotionally laden issue. Some people are comfortable carrying debt, while others can’t wait to be debt-free. Which type of person are you? I have clients who want to pay off their mortgage or student loan debt as soon as possible, while others are fine with making the monthly payments.
While paying the monthly amount due on each of your loans is a best practice, if you want to pay one down faster, I advise you to use the interest rate of each loan as a starting point when deciding which one to pay. The interest rate is the cost of the loan to you.
For example, credit cards can carry annual interest rates of 20-30%, mortgages can be anywhere from 3-5%, and student loans can range from 3-8%. Using these numbers shows us why paying off the credit card balance every month is so important! Where can you make 20-30% on your money guaranteed?
After you determine the various interest rates, ask yourself, what is the opportunity cost if you paid down this debt? What else could you do with this money? For instance, could you invest the money and make a more significant rate of return?
This is a more complicated calculation to make. I stress that it would be quite an accomplishment to equal the 20-30% interest rate of credit cards in the stock market. Maybe if you are an accomplished investor, you feel more confident about making the 3-8% rate of return that would, pre-tax, match the rate of return of the student loans?
Your knowledge and experience with investing will affect this decision. Just remember that there is always an opportunity cost to every decision. This moves us to the last point, which is to build equity.
Build Up Equity
Equity is ownership. We have equity in our homes. We have investment accounts and retirement accounts such as our company 401(k), which also represent equity.
I want to note that paying down debt on an asset like a house or a car increases your equity. But for this portion of the discussion, I am going to focus on investment accounts.
Are you currently contributing the maximum amount annually to your company retirement plan? 401(k) accounts are a powerful wealth-building tool. In my work, I have found that saving 10-20% of your gross annual pay is a fantastic way to build wealth over time. Even if you cannot set aside that much, you should contribute what your company matches. For many people, seeing their investment account balance grow provides positive reinforcement, a feeling of stability, and peace of mind. This is an example of how your emotions can drive your financial decisions.
Summary: Your Financial Mindset
Regardless of which option you choose to do with your extra cash each month, all three described here are worthwhile. Building a cash cushion, paying down debt, and building equity through saving and investing are activities that should be part of your core personal financial mindset.
