Unexpected extra income: should you pay off your debts or save?

Receiving a small, unexpected extra income isn’t an everyday occurrence. Whether it’s a tax refund, work bonus or small inheritance, it always feels good! However, it’s important to think about how you can best use it. It all depends on your financial situation. Here are the steps you should take to find the best solution for you.

1. Take stock of your personal and financial situations

Making a personal or family budget is the best way to know where you stand financially. By calculating and comparing your expenses to your income, you can determine whether you’re already earning a surplus, before even factoring in the unexpected extra income, or whether you’re just breaking even. This will give you an idea of how much flexibility you have and whether you should choose to pay off your debts or save instead.

2. Ask yourself what your personal and financial objectives are

Next, ask yourself what your personal and financial objectives are in the short and long run. For example, if you have planned to take a few days’ vacation this summer, put at least some of the unexpected income aside. On the other hand, if your primary objective is to get rid of accumulated debts, it would be better to put the entire amount towards paying them off.

3. Prepare for foreseeable needs in the coming months

Before doing anything, and especially before indulging in spending the unexpected income on needless and non-urgent purchases (for example, buying a swimming pool, new furniture or a new TV), think first about the priorities you need to address in the short run: Does your house need minor work? Does your car need new winter tires?

4. List your debts and their interest rates

Rather than saving your unexpected income, it might be better to put it towards paying some or all of your debt.

• Therefore, your first step should be to list all your debts.
• Next you will want to distinguish between your “good debt” and “bad debt.” A student loan or mortgage is called “good debt” because it helps secure your future. On the other hand, unpaid credit card balances and lines of credit that you use daily are bad debt. They should be paid off as soon as possible.
• Prioritize repaying bad debts that carry the highest annual interest rates.

As you can see, it is better to focus on quickly paying off your high-interest debts instead than saving.

5. Build up an emergency fund

If you don’t have a large debt to pay off, this could be the time to build up an emergency fund. In the event of unforeseen circumstances (such as job loss or extended sick leave), you will have cash on hand. Your emergency fund should cover three to six months of expenses.

It is best to place emergency funds in a savings account to earn interest. Consult a financial expert to find out more about it. But still keep in mind that paying off your high-interest debts should take precedence over creating an emergency fund.

6. Avoid withdrawing from your RRSP to pay off debts

Withdrawing from your RRSP to pay off debts is a bad idea. The amounts withdrawn will be taxed at source at the maximum rate and will be added to your taxable income. You could also jeopardize your retirement, so avoid it at all costs!

In conclusion, your financial situation will determine what you do. If you have debt problems, you will be better off prioritizing paying them down rather than saving. However, if you have only good debt, you can opt to save.

Moreover, if you realize that you have accumulated a lot of debt, you should get help as soon as possible before your situation gets worse. Our licensed insolvency trustees are there to help you. They will work with you to free you from debt and help you regain financial peace of mind.