Reader Profile: JP

The following is the latest post in my "Reader Profiles" series. Each post in this series details the financial situation and challenges of an FMF reader. The purpose of this series is to help us all identify with people like us (in similar situations -- not all will be, of course, but eventually I'm sure you will find someone like you here), get to know the frequent commenters on the site, and hear some financial wisdom/challenges from people other than me.

If you're interested in contributing to this series, then drop me an email. The series seems to be very popular with readers and I need a steady stream of new ones to keep it going.

Next in the series is FMF reader JP. He answered my questions (in red below) as follows:

Please tell us a bit about yourself.

I'm 33 years old, married (excellent wife, very financially mindful) with one son who is 22 months. We are thinking on a second one.

Describe your financial situation (who works in your family, how your income is (general), how your expenses are, etc.).

Cash Flow

Income: $150,000 a year $8,000 disposable /month (after health insurance/flex $350, 401k contributions $565, and tax deductions $2,400)

• Home - $2,890
• Nanny / daycare - $1,850
• Dining Out - $450
• Groceries - $500
• Bills & Utilities - $700
• Student Loan - $750
• Auto & Trans - $350
• Travel - $150
• Shopping - $200
• Gifts & Donat. - $100
• Personal Care - $100
• Misc. - $30
• Health & Fitness - $50
• Total - $8,005

Balance Sheet

Assets:

• Emergency funds (savings/MM/CDs): $42,000
• Fund to spend on housing (short term investments): $33,000
• Retirements (401k / IRAs): $96.000
• Life insurance policies $1M
• Primary house valued at $460,000

Liabilities:

• Mortgage ($371,000) ARM 7 @ 3.25%
• Student Loan $117,000

What are the current financial issues you're facing (saving, paying off debt, etc.)?

Two key issues, one is trying to reduce expenses while trying to increase income. And the second one is related to housing.

My wife and I are thinking on having a second child, but will need to either move to a bigger home or expand our new one. After doing the financial math and considering what is available in the market for other houses, it seems that it is cheaper to renovate than to move to any of the available bigger houses. The key decision I'm struggling with now is how to finance this renovation.

Option 1 is through short term loans (401K loan -- 4.5%  but with the benefit that I'm paying my self back and the 4.5% interest goes back to my 401K account and also use some credit card leverage (35K - currently I always pay it by month end). Then I'll refinance after renovation is complete and pull some money out to pay most short term loans.

Or Option 2, which is through a not well known 203K loan (an FHA loan that allows you to borrow principal plus an amount for renovation), low fixed rate of 3.25% for 30 years, requires FHA upfront payment, but puts the housing payments at $2,740 for 30 years. Keep in mind that for the first 4 years the comparison can't be made apples to apples as the interest of the 4.5% is pay back to me with option 1 while with option 2, the interest of 3.25% is to the bank. 

What should I do?

What are your plans for the future (retire early, build your career, etc.)?

Maximize income while creating a savings funds so that in the next 5 years I'm able to open my new business. As I do business strategy and transformation consulting, I would like to do business turnarounds on my own (e.g. purchase a small company and flip it).

What's your best piece(s) of financial advice and/or your general philosophy on personal finances?

Absolutely 'Live within your means", but if you want to have a nice live and great means, then maximize your income so that you could continue to live within your means but your "means" are higher / as desired. I'm also a big fan of using Mint.com and creditkarma.com both are free application, great mobile versions and help you tremendously in managing your financials (first one) and your credit score (second one).

Comments

[Kay]

I'm not sure I'd call what you're doing "living within your means" since you don't appear to be saving any of your monthly income at all. Judging by your numbers, I'd bet you're in a high cost of living area. I think if you decide to have another child, you should stay put and look at ways of downsizing your lifestyle to meet the space you have. You still have a lot of student (and probably vehicle) debt... I'd focus on paying that down before you take on any more home debt.

[Bogey]

JP,

I am trying to understand how you've managed to save $42,000 in your emergency fund and $33,000 in additional short term cash savings? It looks like you have every dollar of your monthly income budgeted for a specific expense. Are you still increasing these cash savings accounts, and if so, how?

I'd recommend you try and improve your housing situation without taking on more debt. And even better than that, see if you can find a way to just live within what you already have. That way you can hang onto your cash and also not go into more debt.

Bogey

[JimL]

I pick option 3 - You can't afford the addition/renovation.

Your short term investments need to be part of your emergency account in order to have enough. Secondly, you have a huge pile of student loans. You really need to pay that down before spending more on housing. Third, your life insurance is a bit weak. It should be at least 10x your income at your age. Fourth, why do you have an adjustable mortgage when rates on fixed are low. Since you are planning to expand your home, I would assume that you have no interest in moving.

If I am reading this right, you have $8000 in disposable income and $8005 in expenses. You need to create even more margin and make meaningful progress on the student loans. Also, if you are considering another child, keep in mind that your expenses will rise and you don't have margin for that either.

My final thought is that you should NEVER borrow from a retirement account unless it is an absolute emergency.

Sorry to be so hard, but the steps you are considering would put you in more of a financial bind and I am sure you would not want that to happen

[Luis]

I agree with all the commenters above that your home should fit two as easy as it can fit one. If you need to declutter, then sell off the extra stuff in the house, it makes room and money. Kids beds are so small you can buy your son a twin for your 22 month old and put the second child in his old crib....all in a small 10x10 room! Basically do anything but take out unconventional loans.

I don't see some expenses that should be up there but maybe they are consolidated somewhere, like Roth IRA ($416), 529 plan (~$300), all insurances (life, STD, auto, and home insurances, etc.) What about next car fund?

Can you go without a car, or reduce your mileage by busing? Can you go without a nanny, have family help or take on the burden and become a 24/7 parent. I'm sleep deprived too, but just a few years and it will be behind us.

Good job on your finances, your home equity, salary, and emergency fund are pretty good. Just need to look at cost of living and transfer expenses to those expenses that I detailed which are more important for financial security.

[Dom]

A few things came to mind about your situation - first, your monthly expenses above total $8,120, not $8,005 as shown (can't help myself - I'm an accountant). That puts you at a net cash outflow each month.

Second, your groceries and dining out amounts seem really high. You're spending nearly $1K/month on consumables. It may be that you dine out frequently or get a lot of convenience foods after you're both tired from a day of work. A few questions to consider: Is it possible for the nanny to do any basic meal preparation? Do you purchase only the highest quality groceries for your meals? Are there places where you could buy your staples (beans, flour, sugar, salt, milk, bread, whatever) at a lower price?

It seems that you are doing somewhat ok given your high housing costs and student loan debt, but there does seem to be some room in your monthly budget for savings. If you're looking to open your own business where you could ostensibly purchase a struggling business, you'll likely need more capital on hand. In addition, owning your own business would lead to less predictable monthly cash flow, so having additional cushion (savings) on hand would be preferable.

Finally, have you considered refinancing your mortgage in to a traditional 30 year (or 15 year) fixed rate with 20% down? It appears that you are close to 20% equity (19.35% by my calculation), so you could pay down your mortgage a little bit and lock in to a long term interest rate. ARMs and floating rate mortgages on a primary residence make me nervous, and with historically low interest rates it would make sense to me to lock in to a rate that is comparable to what you pay now.

[elb]

When does your ARM reset?

[Kurt @ Money Counselor]

I have to mostly echo previous commenters: There's no room in your budget to take on extra debt and expense at this point in time. I think you need a Plan C: Cut expenses + grow income + defer baby #2 (i.e., the housing change) until there is ample budget room.

Also, you mention: "Keep in mind that for the first 4 years the comparison can't be made apples to apples as the interest of the 4.5% is pay back to me with option 1 while with option 2, the interest of 3.25% is to the bank." I'd like to point out that the main reason the comparison is not apples to apples is that you're ignoring the 'opportunity loss' of the growth in the 401k funds you'd be borrowing. Borrowing from a 401k is almost never a good idea, imo.

Best of luck!

[Noah]

There are several key pieces of information that are missing that prevent us from confidently giving advice:

1. I'm assuming your wife does work, but it technically doesn't say. What is her income vs yours?
2. Will the nanny be able to take care of 2 children? If so, how much does the rate go up?
3. What city, state do you live in?

I'd say you can't afford to either renovate your living space or have another child. You are maxed out.

[Jonathan]

"Absolutely 'Live within your means", but if you want to have a nice live and great means, then maximize your income so that you could continue to live within your means but your "means" are higher / as desired."

It sounds like you are over-indulging in your own advice, based on the information you've presented here. As others have pointed out, you seem to be on a negative savings path. You have a decent amount of cash saved, so it sounds like you haven't always lived right up to "your means." But as it stands now, you're in a dangerous trend.

Further, you're 33 years old and making $150k, but you don't even have 1 year's worth of income saved up between your 401k, IRA, and emergency funds, and it sounds like you plan to continue growing your lifestyle rather than your savings as your income rises. As FMF continually reminds us, that makes it tougher and tougher to ever have enough to retire.

Finally, Kurt points out that borrowing from your 401k is NOT a preferable alternative to borrowing from a bank. Yes, you're "paying yourself." However, you're robbing yourself at the same time - that money in your 401k is invested in such a way that it should be growing in value on its own. When you borrow those funds, that stops. And, from what I understand, should you leave your job or be fired, you have to repay that debt right away (60 days?).

If I were in your position, I'd first sit down with my wife and set some long term goals - lifestyle, retirement, school and activity expectations for my kids, etc. Then I'd take a careful look at identifying spending that is both not entirely necessary and is not bringing me the sense of value commensurate with the cost (for example - is it really worth it to spend $450 a month eating out? If you're just trying to get out of the house once in a while, could you have just as enjoyable of an evening at cheaper restaurants? Or, if you really reflect on it, would it maybe even be nicer to have a home-cooked meal than taking a potentially fussy 2-year-old out in public?) Finally, I'd make increasing my income a priority along with a commitment to save the majority of the increase as it comes.

Good luck!

[retireby40]

Oh wow, you live in the expensive part of the country. Did you look into how much day care would cost with 2 kids?
Normally, I would say rent out your old place and get a bigger house, but it might be too expensive. Your mortgage is pretty high too. Good luck!

[Tony]

I second most of the previous comments. In addition you are listing $1M life insurance as an asset, I don't think this is right. Anyone can get life insurance, it doesn't mean you can automatically add $1M to your NetWorth statement. If you are going to do that you should also add in the liabilities column the NPV of all future premium payments during the term of the policy (20-30 years).
I personally don't include my life insurance in my NetWorth calculations.

[Ivy]

I won't repeat the points above which I fully agree with, but will add 2 more - if you do decide against all advice here to go ahead with renovation:
- you are still only thinking about having a second child. Speaking from experience, it doesn't always work out even if the first one came easily. Don't invest in renovation until the second child is a fact (or until you know you won't need the money for fertility treatments)
- you already have a housing fund of $33k - how much more were you planning to spend on that renovation that you need to borrow. For a house work $460k, spending 10% of it's value on renovation is a bit excessive, think of the sale price potential

Btw, we have 2 kids now, and we do have an extra bedroom, but I intentionally put them together - and in one room they will stay at least until the older one is 10 (they are different genders, so at that point I imagine they will get big on privacy). It does wonders for making them play together, settle differences by themselves and share.

[PedroNY]

I am not sure what is going on here. $150,000 is for just you or you and your spouse? If she is not working, then why is there $1,850 bill for daycare? If she is working, then why isn't her income listed?

You utilities/bills are $700 + your housing is another $2,890, so you are talking about $3,600/month payment, that's way too high. Definitely do not get a bigger house, and try to figure out how to downsize.

Rule(s) of thumb, if you want to have a good chance at significantly increasing your wealth, then buy a house is worth 2x your annual income, don't go higher than that. Also, save at least 20% of your income. If you can follow both of these rules, you should be in a very good shape.

The price of the house drives almost everything else, from RE taxes, to insurance costs, to utility bills, to buying more expensive cars as your neighbors have such cars, etc.

Definitely, Option #3, don't take out another loan.

[Adam]

I think you need to take a deep breath and reevaluate what it means to live within your means. Paying $750/month on $117k of student debt means your child will be a teenager before you pay it off assuming the interest rate is 0%. If its 4% then they'll be starting college when you pay off your debt- and you dont appear to be saving for *their* college. Nor are you saving adequately for retirement (10-15% of your income).

My advice:
1) Reevaluate everything you spend money on classifying things in to two categories - needs (food, shelter, electricity, insurance) and wants (gym, shopping, cable tv, etc). You could probably cut $1500 out of your monthly spend.
2) Refinance your house in to term shorter than what you have now...15 year fixed @ 2.75% is $300 less than your current payment.
3) Once the dust settles on the refi dump all but $20k of your cash in to your student loan (assuming you pay interest). It should be less than 3 years paying $2250/month (current $750 + $1500 from frugal budgeting) to get the loan paid off.

If everything remained the same after three years you could dump that $2250 in to the house payment and get that paid off in 6 additional years. So 9 years from now you could be completely debt free. Or do it your way (cable TV, eating out, gym, big house, status symbols) and be in debt the rest of your life.

[mysticaltyger]

I agree with all the other posters. I will point out your 401K contributions of $565 a month are quite skimpy given your income. I live in a high cost area of California, make less than 50K per year, and my contributions are $1062..(almost double what yours are). Granted you have a child, and that increases the expenses...but I think it's really clear from your post that your lifestyle aspirations are outstripping your income.

[indio]

Ditto on everything above, but definitely relook at the life insurance. Here's my take on the childcare. The costs could be a big expense beyond the nanny. I live on the east coast and the cost of pre-school, which is usually only half day, can be just as much as nanny. After they start school, there is child care after school and ridiculously expensive summer camp.
I put both of my kids in the same bedroom with bunk beds. I kept one unassembled in the basement until the youngest outgrew the crib. Then the youngest got the bottom bunk with a guardrail. It's saved a lot of money not living in a bigger house and our family is much closer because of it.

[Christine]

Think very carefully before taking a 401(k)loan. You must repay the loan with post-tax dollars, which at your marginal tax rate, counting both federal and state taxes, could be close to 50%. Then, when you want to withdraw that money, you must pay taxes on it again. That is why the IRS code permits qualified loans, because they collect double the income tax. Depending on the time the money will be in the account, potential earnings, etc., it could end up being an OK decision out of all of your options, but I'd recommend taking a second look at your other options and save the 401(k) loan as a last resort in dire circumstances.

As a general comment, it looks like you had some fun for the last couple of years, which is great, but now you might want to rein it in a little bit and keep a closer eye on your budget, just to make sure that you don't accidentally spend large sums of money on small items that don't provide much utility. Good luck with baby number two - it really is 3x the work! :)

[Bob]

The money from a 401k loan is not double taxed. The money you borrow is not taxed when you take it out, increasing your income without increasing your income tax. When you pay it back you are making up for the extra "income" by paying taxes as you put it back in. Thus tax neutral.

[Luis]

@ Christine

You are confusing the difference between a 401k early withdrawal and a 401k loan. On early withdrawal without hardships, yes you will be taxed income plus a 10% penalty on the withdrawal amount.

401k loans do have other pitfalls consumers should be aware of prior to taking the loan. First is the possibility of losing compounding tax-deferred growth. For example, if JP took out a one year loan (12/19/2011 to 12/19/2012)he would have lost 16% growth, or a net of 11.5% (16-4.5%). It is hard to say what the market will be like in 2013 and so that is the risk you play.

There are other risks of course like losing your job or having to take on another job after a company closes down. If you cannot pay back immediately in these instances, then you could stand to lose heavily in taxes and fees.

Lastly, if for terrible luck you fall in really bad times and need to claim bankruptcy, your loan amount is not protected as it would have been if it had stayed in the retirement account.

[jim]

Income and expenses don't add up. $150k is $12.5k a month.
but the listed amounts "$8,000 disposable /month (after health insurance/flex $350, 401k contributions $565, and tax deductions $2,400)" adds up to only $11,315. We're missing $1185. Maybe its saved?

I'll assume you live in a particularly high cost area and you live in a very small 2 bedroom now. If you do end up upgrading the existing house then I'd go with a fixed 203 loan over the 401k. If your house isn't very small then I'd instead make due for now.

[Brooklyn Money]

I have the same salary as you (if that is your salary and not your wife's too?) and the same house value (although mine is an apt). The difference is that I am single and don't have any debt outside the mortgage. When I see your #s, I think you are living close to the line -- I would not feel comfortable. What if you lost your job? I agree with all the other posters that you need to buckle down on saving and figure out a more aggressive debt repayment and savings plan before you think about expanding your family or your house. You have a great income so you should be able to do it, once you commit.