Financial Planning for Generation X & Y Women
 
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Expert Q&A Archive

03/18/2004
Saving or paying off debts.
I work for the US Department of Labor. I make around $76,000/year. I am at a crossroads right now and am not sure of the best way to proceed -I am just now getting to a point where I have some disposable income and I do not know if I should pay off debt, or build savings at this point. If I save, do I just set up a basic savings account, CD's or money market? Here's my situation:
I have almost no savings - around $1000 (in my checking account at the moment - not earning interest)I paid off all my credit cards, so I have no credit card debt.

My debt lies in 3 main places:
Student loan - 7.75% interest - owe $29,000 still -- $309/month
Personal loan (I sold a house for a loss after my divorce) - 10% interest - 14 months left to pay -- $266.42/month Car loan - 4 years left to pay - 5.25% interest -- $216.18/month.

I have between $300-$400 per month to "play" with - would I be better off paying off loans, building savings, both?
Roberta Coates:
expert info »
My advice would be to build up that emergency fund first. The general rule of thumb is to have 6 months worth of living expense in a safe and accessible location, such as a money market account. It doesn't earn a lot of interest but there are no penalties if you need to access it. If you feel extremely confident in your current work position ( no chance you'll be looking for a new position anytime soon), once you've reached the 3 month living expense threshold you may consider taking half of your monthly extra to pay off the personal loan faster, and slow down the pace of building your emergency fund. First priority is to have money you can turn to in an emergency, so you don't have to increase your debt.
Gary Silverman, CFP:
expert info »
While you will definitely need to build up your long-term (retirement) investments (zero being too small a sum), there are two more critical areas to look at: Debt and Emergency Savings. (Note: I am sure that you will hear a wide variety of ideas; mine tend to be a bit aggressive and creative.)
It is good to hear that you have no credit card debt. That gives us more options. I am also assuming that you have a "secure" government job.

While I would normally want to see your emergency savings built up, I am taking some credit here for 1) you are in a position where the chance of layoff is well below average, and 2) other emergencies can be handled with credit cards for now. This does not mean that I want you to always handle emergencies that way...eventually I'd like to see a much larger pool of money to draw from...but for now I want you to concentrate on other areas.

Next, ensure that all of your Savings needs are budgeted. Do you have any payments that occur regularly each year? (Think vacation, Christmas gifts, insurance, car repair, etc.) If you say no then you are not thinking hard enough. List those expenses and divide out how much you need to save each month to pay for them when the time comes. That is the first place you should put your "play" money.

Once you satisfy that category, let's pay off the Personal Loan. Unlike the Student loan it is not deductible. Unlike the car loan it is not at a low interest rate. Check to make sure that there are no prepayment penalties and then pay it down.

Have you done your one-time student loan consolidation? If not, check it out. Interest rates are very low these days and you can save some money that way.

Before I'd pay off the Student loan and the Car loan I'd make two other priorities. First I'd begin slowly building up your emergency savings. Then I'd start contributing to the TSP plan (if you aren't already). Be aggressive here. I know that G & F look safe, but safe doesn't cut it when you need to build assets to use in retirement.

Now, where to put the emergency money and the savings money. Here, I usually prefer a money market mutual fund or a high interest savings account. While I can't make specific recommendations, you should be earning at least 0.3% on your money, and probably quite a bit more. If you know a purchase is more than three months away then you can play with short-term CDs. The key is liquidity: you want an investment that doesn't go down in value and that you can cash in quickly.
Mary Ann Evans:
expert info »
I think you should do both -- decide an amount to save each month, and do it first thing. You won't make much interest these days, but it will give you a cushion.
Check to see if any of the loans have an early re-payment penalty - - possibly not, but check. If not, start making an extra payment to principle if you can. Check with your creditors.
Often splitting the difference is a good choice - half to the debt and half to savings.
Good job on paying off your credit cards!!

Also, if you are making $76 K per year, and you only have 300 a month exra, what are you doing with your paycheck?? Is your housing that expensive?? Child care?? You might look at your spending patterns.
Patricia Howard Byrum:
expert info »
With what you have to work with, the first step would be to pay off the 10% loan. Save the extra for now.
Carrie Bailey Morey:
expert info »
Good job on having no credit card debt--first of all! Keep that up! I have a couple of questions: Do you have a budget? And if so, these debts you mention, student, car and personal, are these considered bills and paid every month? I will assume so. If this is the case, then you are making the regular payments each month and still have $300-$400 left over to spend--correct? OK, so my suggestion to you is to continue to pay off ALL debt! Wait to start your savings until your debt is gone. Leave the savings account alone--you need that and will need to add to that eventually and keep it as your emergency fund. Here is my advice in order of importance:

~Prepare a budget--or continue to live by your current budget (include these debts in budget)

~Take your $300-$400.00 extra each month and apply it to your debt--highest interest first (personal loan). Once this is paid off, continue with the next highest interest rate debt (student) and so one and so forth. This is called the snowballing effect--use all the extra money you can afford to pay off this debt.

~Once all debt is paid off, start adding to your savings--or "Emergency fund." You may want to switch it over to a money market account at this point to get a little interest. Your emergency fund should have at least 3-6 months income and should be left alone for emergencies...

~Max out your 401k or retirement program your job offers you. Remember to diversify!

~After this is complete, start with another investment/retirement account--they can be started for as little as $250.00... remember to diversify!
Dorecia Baggett-Waisome:
expert info »
1. I cannot stress enough the importance of building and maintaining an emergency fund of 3 - 6 months of your expenses in a savings account or money market account (whichever will pay you the most in interest and require the least in fees.) Two primary causes of financial distress in our country are job loss and short term disability, both usually take 3 - 6 months to recover from. However, in today's economy, replacing a lost job can take up to 8 months! You want to definitely secure your financial future with the emergency fund. I recommend that as a #1 priority!
Further, normally a savings or money market account is recommended to hold these funds simply because of their liquidity in the event of an emergency. However, if you think you would be tempted by the cash in your savings/money market account, then perhaps a one-year CD (which you would roll over annually) would be best for you. This way you would probably avoid touching it outside of an emergency knowing that a penalty will be assessed if you touch it prior to maturity. Also, if you do end up needing it, you can always take out a loan against the funds in your CD with a reasonable interest rate. This would force you to pay yourself back the funds you borrowed.

2. Of the outstanding debt you have, fortunately most of yours is what most financial counselors would consider "good" debt. In other words, this debt benefits you. As opposed to consumer debt such as credit cards and other unsecured loans that are usually the result of impulse purchases and carry high interest rates.
The debt that would not fall into this category is the personal loan. However, you have a fairly competitive interest rate on your unsecured loan which tells me that chances are you have pretty good credit, which is great! Also, with only a little over a year to pay this personal loan off, I would not recommended sacrificing the building of your emergency fund to pay this off early. If you do pay it off early instead of saving and an emergency takes place, you'll need to borrow money and you'd be right back in debt all over again.

3. Considering the interest rates on your student loans, you probably have an opportunity to save some money in that area. If you haven't consolidated your student loans, now is a great time to do so. Your interest rate will probably decrease by 2% or more, thereby lowering your monthly payments and increasing your monthly disposable income. You can get additional information regarding eligibility, benefits and application information by visiting http://loanconsolidation.ed.gov/.