Help a Reader: Loan Repayment or Savings

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

Recently, I've had some issues with choosing whether to repay my college debt aggressively OR pump money into a savings account.  I'll give a little bit of background that may be necessary. 

I'm 23 years old living at home so I do not have any rent expenses although I plan to move out towards the end of the year/beginning of 2013.  I have 10k saved in an online savings account with another 1k in a personal checking account.  I net roughly 3200 a month.  My total loan balance is about 55k.  Minimum payments to the different lenders are at 150, 258, 53, and 126 with rates at 7.8%, 6%, 5%, 5.5% respectively. 

After I reached 10k in my savings account, I stopped 'saving' and pumped about 1400 into the loan with the highest interest rate (this loan as a balance of about 10k) while paying the minimum payments on the rest.  My thinking was that if I could knock that loan out before I moved out it would be one less expense to worry about. 

Recently however I have been second guessing my choice.  I'm worried that if I do not continue to save money I won't be preparing effectively for some of my future goals.  I have just started to put money into my 401k but a very small amount. I'll be increasing the contribution once my company match kicks in.

Any thoughts would be much appreciated.

What's your advice for him?

Comments

[Noah]

What is the reason for moving out? Unless you are either forced to or getting married, I would continue living at home as long as I possibly could. Depending on where you move to, you can probably guarantee spending at least $1K month on rent, food, utilities, etc. I know some people will tell you that it's very important to live on your own and while I agree it's a valuable experience, it's much more important to become debt-free. I lived at home until age 27, when I was married. During that time I wasn't making a ton of money, but I still managed to sock away over $50K in savings and investments. That would not have been possible if I had been living on my own or with roommates.

[KJ]

I'd see if you qualify to consolidate all your school loans together into something with a lower interest rate.
I'd also make sure if you are set on moving out that you're smart about your space "needs" versus your space "wants."

[Matt]

I lived at home until I was able to first pay off my student loan and then able to buy a house.

I think you are wise in getting rid of you highest interest loan first and then work on the rest. Once you pay off you high interest loan then start contributing more to your 401k. For each loan paid off then start contributing more to your 401k. You still have time and the market is not going gang busters so the best thing for you to do is get rid of that debt.

[Kay]

If you're worried about contributing to retirement... start a Roth IRA, which you'd max at ~415/month, contribute to your 401K up to your company's match, and see what you have leftover. I'd guess, conservatively, about 2500.

Regardless of whether you move out (Noah's right, ~1000/mo is a good estimate), I'd make sure you're contributing to retirement at the amounts I mentioned above. You don't have to completely go all out when paying down your student loans. Maybe just pay 800-1000/month on loans, and save the rest until you feel comfortable with your e-fund (that 10K you have right now). The key to paying down your loans is to keep paying that same amount every month even as your loans disappear, giving you that snowball effect.

[Kurt @ Money Counselor]

Some thoughts:
- Investigate consolidating these loans at a lower rate. Google 'student loan consolidation.'
- If you must move out, think about getting into a situation with a roommate or two to save living expense.
- Every dollar you pay toward the highest rate loan is just like making an investment with a guaranteed return of 7.8%. Think about it.
- Given your age, I'd hold off aggressive retirement investing until you have at least the 7.8% loan paid off (or eliminated through consolidation)
Good luck!

[sb]

Having just paid off my student loans a couple months ago, I can tell you it is a great feeling and I'm happy with my decision. Having the extra cash flow is nice as well, but I admit that my savings could be much higher at this point.

Honestly, you don't need much in emergency savings right now. If you lost your job, I doubt your parents would kick you out, you would only have the debt repayments. Obviously if you decide to move out, that changes everything.

My suggestion would be to start contributing to a Roth IRA and up the 401k to the company match. Everything else can be put into the student loans.

Regarding loan consolidation:
When I looked into this, there wasn't much benefit to it other than having a single payment and a reduced minimum monthly payment. The interest rate was the weighted average of all my loans. If you want simplicity, you can choose this method. However, as it is now you can pay off the higher interest rate loan first (instead of averaging out over the loans) and a lower minimum monthly payment doesn't help much since you pay more than that anyway. Unless you can find a better deal than I could, I wouldn't bother.

[Dirac]

This is simply from my own experience: once I had an emergency fund set up, I started aggressively paying off my private loans as the interest rate was higher than just about any investment return out there.

I do like the advice already given to contribute to a Roth and your 401(k) up the the company matching amount but it seems that fewer and fewer companies are matching so that might not be an option.

As for consolidation, even with a lower rate, you will end up paying more for the loan over time unless you get some sort of amazing deal. I was not able to do this. I was only offered a 2% drop in interest rate to extend my loan another 15 years. It did not add up.

[jim]

Yes I think that paying down that 7.8% loan right now is a smart choice.

What are your other goals? You don't say. If you have broad eventual goals like maybe eventually buying a house then I'd say saving for those can wait till your loans are paid down. At least pay off the 7.8% and maybe 6% loans. The 5.5% and 5% rates are pretty low interest and I wouldn't be worried about paying them off fast.

Make sure to take full advantage of the employer 401k match when you can. As long as you're saving ~10% towards retirement combined then I'd put extra money towards the student loans.

[Mert]

First, your interest rates are very high. Consolidate if possible.

Then, by all means, I am for moving. Still, if you don't have any problems with parents, just postpone it 3-4 months more. Less debt will help you when you move.

Also, when you move, you will have lots of one-time and recurring expenses. I suggest you to buy everything secondhand. Yes, everything :)

Finally, as long as you don't move, that 10k in the savings is too much as an emergency fund (IMO). So, pay your debts with some portion of it (let's say 5k).

Good luck!

[Carol]

Have a larger emergency fund, fully fund your 401k company match as well as a Roth IRA. and continue to pay down your loan, in that order.

[Jake]

Assumptions:

1. Your net of 3200 is after the 401k contribution has been made.
2. All of your loans are federal student loans that are eligible for consolidation.
3. You can deduct the student loan interest based on your annual income.

Steps:
1. Project your living expenses once you move out. Include rent, utilities, transportation costs, insurance, food costs, clothing, entertainment and any other current living expenses. Once you know what these will be, determine what your monthly costs will be.

2. Make sure you have 3 - 6 months of living expenses in liquid savings. If you are conservative by nature, tend toward 6 months.

3. If all of your student loans are federal, then consolidation probably won't help that much. Despite what many people think, student loan consolidation rates are not that different than what a graduate is already paying. In fact, the new rate on a student loan consolidation is simply the weighted-average of someone's current loan rates, rounded up to the nearest one-eighth of a percent (.125%). Federal student loan consolidation rates only apply to Federal loans such as Stafford, Perkins, and PLUS loans.

4. If all of your loans are private loans, you would have to work with your lenders. Private student loans may also be consolidated, but not under the Federal consolidation program. Be sure to talk to your private lender to explore the available consolidation options.

5. Make sure you are maxing out that 401K to the match maximum when you are eligible. Remember, that is "free money" up to the match. For instance, if your company matches 3% of salary, target that much to defer and move on.

6. Start paying down the loans from highest interest rate to lowest interest rate like you are doing. Your student loan payments total $587 monthly. If you pump $1400 additional dollars into each loan, then the 7.8% one will be paid off in about 7 months. Rollover the $150 payment from the 7.8% and the $1400 into the 6% (that you are already paying $258 into) and start paying that one down. Proceed down the list. At basically 2k per month, you should have the loans paid off in about 24 - 28 months. Ask yourself if you would trade another year to year and half with your parents to be debt free?

7. Don't worry about interest rates so much on the student loans. Often times you will see that you can deduct the student loan interest so you are really only getting a return of 7.8% less your tax savings. But the big benefit to paying off the loans while your expenses are low is that you are freeing up cash flow for when you move out. Once you are debt free and have almost 2k freed up, you will be in a much better position.

8. Once you have all the loans paid off, redirect 5k per year into that Roth IRA on a monthly dollar cost average approach.

9. Now that you are debt free, have an emergency fund fully funded, funding retirement through both tax-deferred and tax-free vehicles and have basically 3200 of free cash flow, search out the best possible deal for a rental (roomies?) or start saving for a house.

10. Rock out to the fact that you will be 25 and have no debts, a great job, good retirement savings and lots of good cashflow to do what you want. Career opportunity comes up that requires a move? Do it. Go backpacking for a month? Check.

Best of luck!

[Old Limey]

Those college loans are a huge mill stone hanging around your neck. We are also NOT in a period where you can safely make more money on investments than you are paying on the loans. With no investment experience you would almost certainly end up losing money.

My advice - Be extra nice to your Mom and Dad and stay living at home as long as you can possibly stand it. Once your 401K company match kicks in your highest priority should be to max out your contribution. You are in an extremely tough situation, even if you put your whole paycheck into loan payments it would take 18 months to get rid of that mill stone. I hope your education costs will prove to be well worth it.

Your ideal solution is to have a wonderful woman with no student loans and a great job fall in love with you and move in with her but that's a real long shot. It does happen though with doctors and nurses.

[Luis]

What are your future goals? I'd say for one that anyone's future goal should be to be prepared for retirement. With that said, I love SB's advice.

Make sure you have at least 5k in a Roth IRA before the end of the year. Once the deadline hits, you lose the opportunity to contribute. This is more than just comparing rate of return on student loans versus your IRA. This is about compounding interest and opportunity to invest the full limits of the Roth IRA in the given year. You can prepay your student loans aggressively in 2-3 years, but think twice about losing out on two years worth of Roth IRA contributions.

Again, I repeat, set aside 5k each year for Roth IRA and then throw the rest into the student loans as you wish.

[Josh]

Don't move out until you have the loans paid off and enough saved to buy a house for cash.

[swiehn]

I'm not sure why you want to move out. But, with living expenses being high once you move out, I would give my parents money to help out with the expenses and stay there until I had the loans paid down or completely paid off. Even if you give your parents half of what it would cost you to live on your own, you could pay your student loans much easier and faster.

[Kay]

I echo Luis's sentiments - time is on your side at 23. Roth IRA max first, then 401k as you feel appropriate. The thing is, your tax rate will be relatively low now compared to 20 years from now when you'll be making more money... thus deferring present taxes isn't the best idea for retirement savings.

Once you've gotten to a place where you're investing in your retirement to your satisfaction (10% of your total monthly income is a good number to try to hit), THEN focus on saving/paying down loans. DO NOT compare interest rates of loans to ROI in the stock market... that is quite possibly one of the most dangerous pieces of financial advice I've ever seen, especially for someone who's under the age of 30!

[JR]

I bet he wants to move out because he's still young and wants to enjoy his younger years while he can. Maybe he wants to sacrifice some retirement money for some pleasure in his 20s?

[Jacob]

I would have to agree with what Jake posted above.

1. Live with your parents as long as you can. Unless you are moving out due to you being unable to live there anymore by their choice. Depending on your relationship with them, It may not be the best living arrangements, but it is definitely worth it (financially) for you to continue to live with them.

2. I think it is great you have managed to save up so much (10K!) however I think with the current state of your expenses and income, you could afford to use a lot of that (~5k) towards getting rid of your student loans. This will help you get those loans paid off faster.

3. Although it is a good idea to invest early, paying off your student loan that is at 7.8%, is NEARLY IDENTICAL to you investing that money in an IRA that returns 7.8%, AND that 7.8% on your student loan is GUARANTEED, your investment is not. A 7.8% guaranteed return is great! Now that amount becomes less appealing as you move onto the lower interest rate loans but even at the smallest interest rate of 5%, that is still pretty good for a guaranteed rate.

4. Once you have your student debts paid for, then start contributing $5000 a year towards a Roth IRA and saving any extra for either moving out and renting or purchasing a home.

[Adrienne]

I agree with Luis on the Roth IRA. However, he is incorrect with the end of the year being the deadline for contributions. You have until April 15th of the following year (or whenever the tax deadline is set) to make contributions. So for tax year 2012 you can make contributions up until April 15, 2013. Once 2013 hits, just specify with your brokerage firm that they are to be applied to tax year 2012. Makes it easy for those trying to catch up.
Once the 401k match kicks in definitely take advantage of it. Also, may not be what you want to hear, but I'd look into a second job..or better paying job. If you decide to move out, you may need to.

[AD]

I’m guessing you’re not moving out for financial reasons, but because either you or your parents want you to grow up and live outside of their house. I’m 25 and have my own apartment; I’ve seen lots of friends and my brother move back in with their parents. Sometimes it’s tough to tell if it’s more difficult on the child or parent when they move back home. Being on your own costs more but can lead to a much healthier and adult relationship with your parents. Budget accordingly, get a roommate, move out, learn to be succeed and fail on your own, and enjoy your 20’s. Set a goal, such as when you pay off your 7.8% loan you can move out.

Living on your own, a $10k emergency fund could be on the low end, but probably safe enough depending on your expenses. I would increase your retirement savings to at least 10% and then put any excess cash flow into your student loans.

A Roth IRA is a good way to diversify between tax-deferred and tax-free, but with a net income of $3200 a month, your salary will probably get close to the student loan interest phase out, which starts at an adjusted gross income of $60k, within your next few raises. You should be aware of it and use your 401k contribution to make sure you stay below the phase out. You essentially fall into a 41% effective tax rate if it affects you (25% tax bracket + 16.6% phase out ($2500 deduction phased out between $60k and $75k AGI).

Finally, I disagree with Adrienne’s comment that you need to look for a new job if you want to move out. A $3,200 net take home pay I’m guessing is around $55k annual salary at 23 years old. This is right around the median household income; more than half the country has managed to live outside their parent’s house on less than this. If you accumulated 55k in student loans, you probably have a skilled job that will have raises far in excess of 3% as you gain more experience.

BTW, I’m 25, live in a “high cost” area with a roommate, have $48k @ ~4% in student loans, $3,500 net pay, contribute 10% to my 401k, have an emergency fund of ~15k, enjoy not living with my parents, but love to visit them.

[Mariae]

I totally agree with Noah (the 1st commentator)..I honestly don't think there anything wrong with living at home while you're not married. In a small way or the other, you can save a lot. The commentators here are all very helpful to share some tips to you. Good luck!

[Easychange]

What i would do is stay at home but treat it like you are renting. Pay the parents some few hundred dollars per month. If you can swing that, paydown debts and still add say 750/month to your savings for 6 months, then you are probably ready to move out. Paying rent now will keep it real and strengthen your bond with parents and there will be more mutual respect.

[Jenny]

Yes, the advice to stay at home is probably the best financially, but it might not be the best for you emotionally. Once I started college, I never went home again, eventhough I could have. It may have cost me a good bit of money, but staying at home would have cost me my adult youth. So I say, if you want to move out, you should. There's a certain amount of pride to being able to strike out on your own and not have to rely on your parents for help.

That being said, you have about three months income in your emergency fund. If you want to live on your own, I would try to double it before you move. If you don't mind waiting to move for another year, I would apply half of your emergency fund to the loan you're paying down, payoff the rest as soon as you can, then replenish your emergency fund before you move.

You have to strike a balance that works for you. Paying every extra dollar to student loans seems to be causing you anxiety in regards to your savings, but the reverse will cause frustration in the length of time and interest paid for loan payoff.

Oh yeah, and at the very least contribute to your 401k to get the match from your employer as soon as it's available. That's free money that you don't want to be missing out on!

[Margo]

I echo what Jake said - you don't benefit from consolidation if your loans are recent, all-Federal fixed-rate loans.

One thing most people don't know: paying extra on your student loans will never result in a lower payment, but takes months off the end of the loan. So no matter how much extra you pay on the high-rate loan, until it's gone you've got $587/month in committed payments. And if you consolidate you'll definitely owe $587/month for the foreseeable future.

On the other hand, if you go at that high-rate loan like a ninja, it can be gone in a year or less. After that your committed payments are only $437/month.

Then year 2 you have $150/month more flexibility to save, pay debt, or invest.

As great as a Roth can be, those investments do go down, too. I regret focusing so much on my Roth in my early 20s, because it means I'm behind the 8-ball when it comes to the late 20s cash-sucking life events: buying a home, paying for a wedding, etc.

I have competing agendas - the loan pay down and the 'big life events'. So, I've allowed myself to switch focus every 6 months. I avoid goal fatigue and I still make huge progress toward both in a single year.

I think you're on the right track. See if you can hold out on moving for the next 6 months - rents will be cheaper in the fall than early summer, so you can snag a better deal. Set a date. Then while you wait, get as aggressive on your 7.8% loan as you can.