At some stage in life most people experience the relief of having surplus income, that is, income not needed to pay rent or mortgage, buy groceries, raise children or pay for essentials. It can come about due to pay rises, paying off a credit card or personal loan, or a child getting a first job.

Splurging on personal desires is one way to use surplus income, though perhaps not the smartest. Wealth accumulators who aren’t close to financial independence or retirement should think carefully about the options they have, and which will be the best application of that income.

One option is to pay extra on the home loan. Another may be to start a savings plan that can be used to pay for major costs in the future. A third option would be to pay extra into superannuation. A fourth could be to borrow to buy investments, using the surplus income to pay loan interest.

Each option has its benefits. Paying extra on the home loan reduces the debt more quickly, saves interest and builds equity in the home faster. It also gives a guaranteed return, at a lower rate – the interest you don’t have to pay on the loan amount repaid early.

Paying extra into superannuation has the big appeal of saving tax for medium and higher income earners. Contributions are tax deductible but incur a 15 per cent entry tax. So workers save 32, 39 or 47 per cent tax, less a cost of 15 per cent. 

Ongoing extra super contributions over a long time benefit from the power of compound interest. If earning rates are good, a large extra super balance will result. However super is inaccessible until at least age 60.

A regular non-super savings plan can also build up remarkably with compounding interest. Contributions into a managed fund investing in shares or property in Australia or overseas usually earn high returns long term.

The savings can be used for any large future cost, such as to fund children’s education costs including private school fees. Other uses could be for a major overseas trip, or a new car.

Using surplus income to service a loan taken for investment purposes should be carefully planned but can earn high returns and be very tax-effective. The loan interest is tax-deductible, unlike home loan interest.

The investment loan can be taken to buy a property. The surplus income can be used to meet the shortfall between the net rental income and the loan payments. Property loans need to be large.

An investment loan can also be used to buy a portfolio of managed funds or shares. The loan size can be varied to suit the investor. Imputation tax credits can make the plan very tax-effective.