Today’s post comes about as a result of another reader getting in touch with me for advice on his situation.
This time, the subject is someone with a slightly different profile. He’s got loads of student loan debt, but used those loans to land himself a very high-paying job.
Interesting, right? So without further ado, let’s talk about Peter.
His profile and goals
Peter is a single guy in his late 20s who lives and works in Manhattan. He holds an advanced degree and has a great job in a pretty stable industry, in which his already high income is likely to double over the course of his career.
For now, his primary short-term goal is just to do the smartest thing with the money he’s got left at the end of the month, when deciding whether to invest in his company’s 401(K), put money into an IRA, or pay off student loan debt.
Down the line, he’d like to buy a house, stuff a family into it, and have sweet barbecues that he’ll invite me to. He doesn’t have much of an idea of when that will all happen or to what scale, but it’s probably safe to say that if he sticks around New York, all of this is going to be pretty expensive. He anticipates retiring around 65.
Let’s start by looking first at his current holdings. It’s worth noting first that Peter has a very high self-worth; he’s flush with knowledge, is passionate about life and has a great set of values, has his health, and has family and friends who care for him. In a way, he’s richer than any person sitting on a fat bank account.
However, in another, more accurate way, he’s not. Let’s look at the numbers:
What he owns:
- $15,000 in retirement savings
- $18,000 in cash and cash-like assets, which he leaves untouched, treating it as an emergency fund
What he owes:
- -$110,000 in student loans, broken down as follows:
- -$10,000 at 8.25%
- -$70,000 at 6.5%
- -$30,000 at 5%
This adds up to a net worth of:
All told, he’s got a very negative net worth at the moment.
But don’t feel too sorry for him just yet! Let’s look at income.
Income and spending
- Peter primary job pays him a gross income of $16,000 per month
- His company matches his 401(K) contributions up to 4% of his salary
- -$5,100 in taxes and health insurance (Leaving him with a net pay of $10,900)
- -$2,400 in rent
- -$1,900 in household expenses (food, utilities, entertainment, etc.)
- -$100 in transit costs
This leaves him with disposable income of $6,500 at the end of each month. But holy cow! Did you see that income?
Debt. It’s pretty easy to spot the problem; the one blemish among Peter’s otherwise great finances is the student loan debt. Obviously, he used that student loan debt very effectively, but getting rid of it is still definitely the thing he should focus on.
Emergency fund. In terms of keeping an emergency fund, I think his cash holdings are fine; $18,000 could cover his monthly expenses of $4,400 for four months, or slightly less if you factor in that he would need to find health insurance for himself in the event of a job loss. On the other hand, one would presume he’d cut down on discretionary expenses during unemployment. Offhand, I would say that getting to six months would be better, even if the distinction between four months and six months feels pretty arbitrary.
Budget. Looking at Peter’s monthly budget, it’s tough to see anything that I think is a huge problem. The income is terrific. Rent and household expenses could both be lower, but even now, each are only around 20% of his take-home pay.
Taxes. It’s not a problem (or at least not a problem he can affect) that his biggest single monthly expense is taxes, but it does affect the way I’ll think about my advice in the next section.
Keep an accurate budget. Oh, also the fact that he lumps so many categories together makes me think that $1,900 is just a total guess.
The first thing I would advise Peter to do would be to thank his lucky stars for having such a great job. The second would be to suggest that he keep his lifestyle inflation at a reasonable level. I’ve spoken to many people at his income level and above who feel like they’re just treading water.
As for how to best use that leftover $6,500 per month, I would do the following.
Until the $10,000 in student loans at 8.25% and the $70,000 at 6.5% are paid off:
- Send the first $700 to your 401(K). This will cover the employer match to 4%. It’s never a good idea to turn down free money.
- Then, send the remaining $5,800 to your higher-interest student loans. I can explain.
Because your income is over $75,000, your student loan interest is not tax-deductible, so your nominal rate on your student loans is also your effective rate and those effective rates are very high.
Here’s a way to think of it: Every $1 can either be put in your 401(K) or sent to your student loan debt. Each would increase your net worth by $1 immediately. Each year thereafter, the dollar in your 401(K) would increase in value some amount based on increases in the equities or bond markets (depending on what you invest in), whereas the dollar sent to debt would prevent you from being charged exactly 8.25 cents each year. In effect, you would earn a guaranteed return of 8.25% — something those who invest in the equities or bond markets can only dream of doing in the long-term.
Paying at this pace would knock out your 8.25% loan in two months, then knock out your 6.5% loan in just over a year.
And, for what it’s worth, investing in a Traditional IRA would act roughly the same way as investing in your 401(K) with the exception of not getting any of it matched. At your income level, you would not be able to contribute to a Roth IRA. (Source: IRS)
Once the only debt you have left is the $30,000 at 5%:
- Send the first $500 to your emergency fund. With the goal of getting the total to fully cover your expenses for six months of unemployment. This should take one year. Moreover, start thinking up a plan for the steps you would take in the event of a work emergency. This might include thinking about what expenses you can cut, and how you might find that next job. This post might help.
- Then, send $1,460 to your 401(K). This would take advantage of your employer match first, then allow you to hit the annual limit of $17,500.
- Then, send $460 to a Traditional IRA. This would allow you to hit the annual limit of $5,500.
- Then, send the remaining $4,580 to your student loan debt. You would be able to pay this off in just over six months.
Amazingly, even without focusing all of your spare funds on it, you will have all of your debt paid off in two years.
And finally, once you have no debt, you should start looking into other tax-advantaged options like 529 plans (if you plan on having kids whose education you’d want to fund) and Health Savings Accounts, tax-friendly investments like real estate and municipal bonds, and taxable investment accounts. Though, at that point, if you’re still putting away over $70,000 per year, both the fact that the picture gets so much cloudier and the fact that your investments become so dependent on their tax advantages, it may be time to seek out professional help.
And wow. That went fairly long. Does anyone else have more suggestions for Peter?