Debt-Defying Moves

I recently got a substantial raise. Should I be applying the extra money toward retirement or debt?

The first thing to do is celebrate: Throw a party or book a table for two at an overpriced restaurant. (After all, not too many people are getting fat raises these days.) Once the hangover has worn off, then it's time to figure out how to allocate that extra cash. Here's some advice:

If you haven't done so already, first create an emergency fund. This should be three to six months' worth of expenses held in a cash account, such as a money-market fund. (To find the best rates, visit Having money readily available will create a safety net in case of job loss or other financial crisis and keep you from racking up painful penalties by tapping into a retirement account prematurely.

Next up? Make sure you're taking full advantage the company match in your 401(k). You simply aren't going to find better investment returns anywhere else in the market (at least on a consistent basis). Of course, with $100,000 in savings, it sounds like you're doing this already. (And for what it's worth, the planners we spoke with said that a couple in their mid-30s with $100,000 saved is in fine shape as long as they continue to save.)

Now let's talk debt. Fact is, there's a world of difference between relatively low-interest, deductible debt, such as student loan and mortgage debt, vs., high-interest, nondeductible debt, like credit-card debt. (For more, see Debt and Your Taxes.) As you mention, the debts you're carrying are relatively low rates. But since the car loan is nondeductible and the car is depreciating in value, it's probably worth tackling this first before allocating anything more to your retirement account. Consider paying it off completely or at least doubling up payments to get rid of it faster, says certified financial planner Diane R. Maloney of Beacon Financial Planning in Plainfield, Ill.

If it will still take many months to pay off the car loan even with the extra payments, you could consider refinancing the loan. These days the average 60-month car loan is 6.01% while a 36-month loan is 5.68%, according to However, this will only be a viable option for those with flawless credit. Another option would be to pay off the loan using a home-equity loan or home-equity line of credit (Heloc). (These days, the average rate on a $10,000 Heloc is just 4.42%, and that's before the tax break on the interest.)

The student loans and mortgage debt are less problematic, since they're most likely tax-deductible. As you probably know, up to $2,500 in student-loan interest is deductible per year, provided a couple's adjusted joint income (AGI) is less than $100,000. (The deduction phases out for couples with income between $100,000 and $130,000; for singles with adjusted joint income between $50,000 and $65,000.) As with most itemized deductions, eligibility for deducting mortgage interest begins to phase out in 2003 for those with AGIs of $139,500 ($69,750 if you're married and file separately).

The question is, do you think you'll get a better return by investing or paying off your debt? If you invest aggressively in an equity mutual fund, you can reasonably expect a 9% return over the long haul. This means that on a pure numbers basis, after tackling the car loan and setting up an emergency fund, you'd probably be best off investing most of your new raise rather than paying down your tax-deductible debts more rapidly. Then again, a more conservative investor may simply feel more comfortable getting the "automatic" return provided by paying off a debt.

Regardless of which camp you fall into, you may be able to squeeze out additional savings by reducing the rates on your loans. One way to cut the student loan rate further is to consolidate the loans (assuming you haven't already done so) or to sign up for automatic payments. Most lenders will also reward customers who make regular on-time payments over a certain period of time.

And while your mortgage rate is quite low, if you have excellent credit, you may be able to reduce it further by refinancing. (Run the numbers in our Refinancing calculator to see for yourself.) If you have a 30-year mortgage, you also could consider shortening it to 15 years. A simple way to cut down your interest payments is to prepay your mortgage. (Just make sure you aren't charged a penalty for doing so.) To see how much you stand to save, see our calculator.

For more on saving for retirement, see our retirement section.