Help a Reader: What to Do Next

Here's an email I recently received from a reader:

A year and a half ago, I read Dave Ramsey's book and starting making financial changes.  My wife and I have spent the past 16 months working hard to pay off our consumer debts which included $18,000 in credit cards and $21,000 in car loans.  Now that the cars are paid, I'm a little confused on what the next step should be.  We have several financial goals still ahead of us.
 
Stats:

• Age: we are both 28, no kids yet
• Take Home Pay: $7500/month (my wife is finishing a part-time MBA program next year, so hopefully income will dramatically increase)
• 401k: my wife puts in $660/month (10% salary with 4% match, I have no work plan
• IRAs: Both maxed out
• Mortgage PITI/PMI: $1050/month, $145,000 balance (4.5%)
• My student loans: $68,000 @ $500/month (4.2%)
• My wife's student loans: not in repayment until 2013, we anticipate $40,000 total when she graduates

After expenses and retirement savings, we have roughly $2500 left over.  My question is where do I put this money.  Our emergency fund is around $1000 due to the Dave Ramsey snowball plan, so I know that needs addressed.  But how much do I put towards the emergency fund vs. paying down student loans vs. saving for the next down payment (we'd like to move when we have kids which will be in a couple years).  Thanks.

What's your advice for him?

Comments

[Keith]

With the $2500, I would build the emergency fund. You could be at 20k total in less than 8 months. Our primary emergency fund is with ING. Once that is built, I would attack your student loans. Two additional thoughts: enjoy the journey and children could come at anytime.

[JP]

I second building up the emergency fund.

You spend $5k a month in retirement/expenses. You should have at least $20-30k for emergencies...

[Jonathan]

You definitely should have some liquid savings, but decide for yourself what you're comfortable with after taking into account health, job security, etc. If you're a family with two secure and well-paying jobs, marketable skills, both in good health and with expenses significantly less than your income, you don't necessarily need 6 months worth of living expenses sitting around earning bare-minimum returns. But save what YOU are comfortable with.

Secondly, consider making long-term goals. Do you and your wife want to retire early? Do you want to develop passive income? Do you want to focus on growing your careers? If I were in your position, I wouldn't worry about trying to pay off the mortgage or student loan debt any faster than required. They're both at low interest rates and they're both "good" debt (as opposed to consumer debt). You should be able to do much better than a 4.5% return by investing in whatever assets you prefer. (note: it wouldn't hurt to pay down your mortgage until the PMI goes away.)

[Ryan]

I realize that dave Ramsey's plan isnt for everyone. However, I just want to urge you to stay on track. Now that you have the cars paid off, it is time to start chipping away at that next debt wether that be your credit cards or your student loans

My suggestion would be to take 500 and sock that away each month in savings (your emergency fund)...the balance of that should go straight to debt. Since that is, after all, what the end goal is (being debt free)

[Jonathan]

Okay I may have misread...if you still have the credit card debt, knock that out ASAP and then never run a balance again.

[Michael Goode]

I would suggest upping your wife's 401k contribution (considering your income, the tax deduction should be worthwhile), paying down your mortgage so you don't have to pay PMI anymore (if that is easily reachable) and also increasing your liquid savings (rainy-day fund).

[CT]

You seriously need to get your emergency fully funded for 3-6 months of expenses. That's baby step 3, right after paying off your debt. Once you reach that goal, keep saving that money for paying off the student loan early (not sure how hard it would be to pay on it while she's still in school or if there's a prepayment penalty, so check on that).

Paying off the house is baby step 6--after you've gotten the 3-6 month emergency fund, investing 15% in retirement, and saving for college (since you want kids). Would probably be good to get rid of the PMI, but that's about all I would do until reaching those other goals.

And about getting a bigger house... babies don't take up much room. Don't get a bigger house just because you can "afford it."

[MC]

First, I'd say you should save up and pay the current costs of your wife's schooling--don't take out any more student loans for her. Never go into new debt if you can avoid it.

Second, get rid of that credit card debt--this is a no brainer. It's gotta be much higher interest rate than anything else.

Third, get your emergency fund taken care of. I agree--you need at least $15-20,000 in the bank.

Fourth, pay down your mortgage so you don't have to waste money on mortgage insurance.

Fifth, invest more than you are currently for the long term--tax advantaged retirement accounts where possible, otherwise index fund.
Fourth,

[PawnKing]

Seriously? No comments yet about the $108,000 of student loan debt? I respectfully disagree about the student loan debt being "good debt", especially when they will be paying upwards of $800 per month once his wife's debt kicks in.

My advice is what I did when I had $70,000 in student loan debt around my neck. I split contributions to building up a comfortable emergency fund and student loans. Once I hit my 6 month mark on living expenses, it went all to the student loans. They were paid off in less than two years thanks to aggressive payments.

Imagine your cash flow situation once those bad boys are gone...

[soners]

Goal 1--$11k in Emergency funds over the next 4 months.

Goal 2--Finish off PMI. If you were going to stay in the house, I'd suggest refinancing after PMI but it sounds like you won't be there the 3-5 years it would take to return the costs

Goal 3--Eliminate student loans. 2000/month to the student loans and 500/month to add to the Emergency fund. $108,000 in loans is an albatross no matter what the interest rate.

Goal 4--Finish off mortgage/save for new house.

Ya'll have a great cashflow right now and you should utilize that to your advantage. Kids or a bigger house could significantly complicate the equation so you should put your heads down and plow ahead as much as possible in the next few years. You might consider delaying a house purchase another 5 years in order to eliminate the student loans and build a pile of cash for emergencies and a new downpayment.

Keep up the good work!

[Nathan Rice]

@PawnKink
I totally agree. Those student loan debt amount to more than some people's mortgages, PLUS it's a non-appreciating asset that is probably under a variable interest rate that will make your home mortgage rate seem like a bargain.

If it were me, I'd drop down your wife's 401K contribution to the point where you're maximizing the match, but nothing more. So for you, that means dropping down from 10% to 4%.

I'd probably then take a month or two to build up your emergency fund.

Then, I'd hit your student loans with a vengeance.

That means, $500 you're already paying on student loans + the $2500 you have left over each month + the amount you're saving by reducing your 401K contributions = somewhere in the ballpark of $3200/mo. A little over 2 years from now, your student loan will be history. Then, hit her student loans. In about 3.5 years, you never have to worry about student loans again.

[JimL]

Soners advice is right on the mark.

[AH]

You have several big goals ahead of you coupled with significant uncertainty regarding when you will want to achieve these goals:
- Emergency Fund (need a cash cushion, but no firm deadline)
- Kids (2-4 years? + childcare expenses or decreased takehome?)
- New house (2-4 years? more if yours doesn't sell?)
- Student loan pay-off (sooner is better, but not required)
- Wife's new job (either promotion at work w/MBA or changing companies)

What you need to weather the uncertainty is flexibility...which means cash at hand. I'd recommend putting an extra $500/mth to chip away at your loans and continue your debt repayment momentum, and put the rest into an emergency fund. By Jan. 2013:
- Your loans will be down to $52K
- You'll have $32K in savings
- You'll have a clearer picture of your priorities and where best to deploy your savings

[Rehab Doc]

From the questioner:
Thanks all for the advice. It sounds like those who have followed the Ramsey plan are suggesting to stick to it, so I will probably get a little more liquid cushion then start hitting the student loans harder. I've thought about passive income/rental properties, but you're right, with $100k in student loan debt, that's probably not smart.

[jim]

Increase your emergency fund.

Take home pay is $7500 and I see mortgage of $1050, student loans $500 and $2500 left over. Where does the other $3500 go? Is your wife paying tuition out of pocket or are there some other large expenses? If not then $3500 seems like quite a lot to be spending given your debt level and such.

[Rehab Doc]

The other $3500 is Roth IRAs (@800), Utilities/Internet/Phone ($500) and $2200 for food, clothes, gas, pet care, entertainment, travel, house needs, gifts etc.

[Bad_Brad]

I would do these things, in order:

* Build your emergency fund. I would recommend six months of expenses but with both of you having an income, it's probably less critical for you than for some. It sounds like your monthly expenses total about $5k, so I want you to build up $30k in your emergency fund. So spend the next year doing that.

* After that, get your mortgage to the point where you can drop PMI and have an appraisal done so that you can save that money every month. That's money thrown down a hole.

* After that, start paying extra on the student loans. Pay as much as you can extra on whichever one has the highest interest rate.

* After that, start paying down the mortgage.

Overall, it sounds like you are in a pretty good place financially. Good luck.

[Des]

If it were me, this is what I would do:

1) You don't say whether your IRAs are roth or not, or how much is in them, but I would max out two roth IRAs and call that my temp e-fund.

2) I would boost the Baby Step 1 e-fund to $2k at least, maybe even $5k for a little liquidity.

3) I would throw absolutely every dime and dollar at the student loans until they were paid off. It seems like it will take forever, but it goes quick with your "gazelle" intensity.

4) I would then save like crazy for all the things that were put off during debt repayment (vacations, newer cars, deferred home repairs or down payment, etc.)

I know that's not what most people suggest, and maybe it isn't the right way to do things. But that is what we did a couple years ago (if it matters, we had about $100k gross income, $43k in student loans). I have a hard time believing I will ever regret having those monster student loans off my back, even if I could have gotten a couple percent more by investing the money. We aren't hard-and-fast Ramsey-nazis, but I do feel like his outline is solid, and we use it as a "guideline". YMMV.

[Jonathan]

Rehab Doc,
I know lots of people here won't agree with this advice, but since you mentioned having considered rental properties, I'll tell you what I would do in your situation. My wife and I have been investing in rental properties that cost about $25-$30k in upfront costs each, which includes 20% down payment and fix-up costs. Each one produces $300-$400 of cash flow each month, plus another $100 in mortgage principal reduction. For the same $108,000 you'll owe in student loans, you could potentially buy 4 properties and be making $1200-$1600 per month cash plus $400 in equity. As a possible bonus, if those properties appreciate (they're currently selling for about 30-40% of their 2006-2007 values), you could sell one and pay most of your loan off in cash. But even without that, you'd be earning significantly more than your loan payments and gaining equity in an appreciating asset. And, if inflation occurs over time, the debt you have becomes less valuable. Anyway, that's the way I look at it and the way I would respond in your situation (I still have about $12k in student loans and have absolutely no problem letting them pay off on their own schedule, which will take another 10 years).

[Walden]

I would say to beef up the e-fund to about $5k, then put the majority of that "extra" $2500 towards your student loans. Once your wife graduates and (hopefully) gets a higher paying job, put her increased monthly income towards them as well. I would hold off on saving for a downpayment until those student loans are significantly paid down. Besides, you won't really "need" more room for a child until they are older.

[CoolMouseLuke]

Stop 401k contribs - $660
Stop Roth contribs - $800
$2500 + 660 + 800 = $3960/mo

Take 3 months and max two Roths's, as a mini Emergency fund as someone mentioned - contributions can be withdrawn in an emergency with no penalty. If you have contributed enough in the past you may not have to contribute more.

Then take the whole amount and attack the student loans. Don't hesitate, do it now while you have the cash flow. When your wife starts working, and/or your income goes up, go immediately after hers also. DO NOT buy a huge house while you still have this large debt.

BTW - I love rental properties and have many, but I would not touch them till you clean up your $100k student loans.

[Clearly_Irrational]

Build up that emergency fund!

I love rental properties and have several, but I agree with most of the others, pay off your student loan debt first.

I think paying down your mortgage is more questionable this early, especially if you're will to consider rentals.

[jim]

Yes sorry I didn't notice you were maxing out the Roths.

[Holly]

Even if you live in a high cost-of-living region, I think that the $2200/mo. for food, clothes, entertainment, gifts, pet care, etc. is pretty high for two people w/o kids. (You mentioned this information a few comments ago.)

I would suggest that you take a look at that spending and try to cut out any waste. Then use some of that to cut through those student loans even faster.

[Cj]

Hmmm i'd say stick with Ramsey's baby steps..

1. 1K emergency fund

2. Go after your debt.. credit card, student loan focus on smallest to largest and just do his debt snowball.. All your other goals will be much easier and faster to accomplish after you have no debt but the house.. you don't need to be doing the retirement funding while you do this step since you are freeing up cash here to catch up later..

3. Now can do your proper funded emergency fund.. and around this time save for bigger house.. i would assume without the debts you would find it easier to get a bigger house etc...

and just keep on going through the steps.. they are simple and straightforward.. your income is awesome so the more focused you are on one thing the faster that goal will be accomplished.. if you spread yourself too thin you won't feel like your getting as much done..

hope this makes some sense! and i'm not out in left field!

[SR]

I recommend you:

1. Small E-Fund of $5k or less, depending on your comfort level and risks.
2. Aggressively pay off debt. Yes, this includes Student loan debt. Why are you contributing to retirement plans when you have student loan debt? My wife and I recently paid off almost $70k in student loan debt. It's amazing how fast it pays off, when you're "gazelle intense". Your current spending allocation is like using splitting a fire hose multiple times to fight multiple fires. I recommend you use the entire fire hose to fight one fire at a time.
3. Of course, after you're debt free except the house you can fully fund your e-fund and aggressively save for retirement and invest.

[SR]

Edit: Continuing 401k contributions to the extent required to receive any match is acceptable.

[soners]

I think using Roth IRAs as potential emergency funds is ludicrous. First, you're absolutely robbing yourself of future tax free growth potential. Second, it's not that liquid (would take several days to get to). Third, YOU ARE ROBBING YOURSELF. I would short sell a house, get rid of a car, donate platelets and many other things before considering a Roth withdrawal. I just don't think it's a good idea to conceive of a Roth IRA as an emergency fund vehicle.

If the OP anticipates future emergencies, financial rough patches, or significant life changes, they should plan ahead by reducing the 401k contributions and diverting more cash to the Emergency fund. But OP didn't indicate that, so I think he's ok. He did not say what the gross total of retirement savings is but I might consider reducing the 401k contribution to the match IF that total is over $50k.

And as to the rental house idea--sure, it's something to consider that has successfully provided positive cash flow to lots of people. But you're a Dave Ramsey disciple right? You know that he got himself into his whole mess doing precisely that, right? I think there are cases where building a rental portfolio could make a lot of sense but the OP is not one of them. After PMI and student loans are eliminated and they have a solid idea about their own housing future, then they can revisit the idea.

[Rehab Doc]

@Soners

401k - $15k
Roths - $18k

I have liked the Ramsey plan so far, but it had seemed daunting to stay with it for another few years to eliminate the student loans. I thought I could use a "multiple hoses for multiple fires" approach, but I plan to get the Efund up to $5k-$10k as we don't forsee rough patches ahead, and hit the student loans hard. I still plan for continue my current Roth and 401k contributions. I got a late start because of grad school (I'm a DPT) and don't want to wait until I'm 31 to start making significant contributions to my retirement account. Thanks all.

[Maria Perez]

You should stick to Dave Ramseys 7 Baby Steps and find a finacial peace class near you to take. Good Luck and your future will be very wealthy starting young.