Using savings to start zeroing debts

[bigkid70]

Hi,

I recently got on board with the MMM philosophy, and so now I'm starting to prioritize my debts to figure out where to start. As the subject says, my question is about using my savings.

I have about 5K in an ING savings account (so it's earning some interest). This is all the savings I have at the moment and it's my emergency fund if I need a fairly large amount of cash on short notice. I would appreciate some mustachian's opinions on a) if I should apply the money it to any debts?, and b) if it's a good idea to use it, should I use it to completely pay off a car loan or put it towards my highest credit card balance (~25K)?

Thanks in advance!!

[ioseftavi]

I have about 5K in an ING savings account (so it's earning some interest). This is all the savings I have at the moment and it's my emergency fund if I need a fairly large amount of cash on short notice. I would appreciate some mustachian's opinions on a) if I should apply the money it to any debts?, and b) if it's a good idea to use it, should I use it to completely pay off a car loan or put it towards my highest credit card balance (~25K)?

Could you list out your debts, amounts, and interest rates?  That'd help.

In general, with interest rates very close to 0%, it is worth taking idle cash and paying off high-cost debt.  However, you need an emergency fund of some kind. 

How much do you spend each month?  If your monthly spending is $1,000, you probably want to keep at least $3,000 in cash as your emergency fund.  If your monthly spending is $2,000, then you don't even have 3 months of expenses saved up, and you probably can't spare too much of your e-fund to pay down debt.

[plainjane]

I have about 5K in an ING savings account (so it's earning some interest). This is all the savings I have at the moment and it's my emergency fund if I need a fairly large amount of cash on short notice. I would appreciate some mustachian's opinions on a) if I should apply the money it to any debts?, and b) if it's a good idea to use it, should I use it to completely pay off a car loan or put it towards my highest credit card balance (~25K)?

How much money do you have to throw at the cc debt/replace your e-fund on a monthly basis?  What rate is your cc debt?  Your car loan?  How secure is your job?  (If 25k is your highest cc balance, what are the rest, and what are their rates?)

In general, it would be more meaningful to put the money against your highest cc rate than the highest balance.  Or, if you have a card with a "small" 2-3k balance, it would be really good to pay that off completely, so that you have a card that you could use without getting hit with more interest (if you pay it off in full each month - check the fine print, some cards are now requiring you to have paid off in full for a certain number of months before they have ).

[Jack]

In general, it would be more meaningful to put the money against your highest cc rate than the highest balance.

In general, it would be more mathematically optimal to pay down the card with the highest interest rate.

It can sometimes be more "meaningful" (as in, more motivating) to pay down the card with the smallest balance first (see also: "debt snowball method")

I suggest using the mathematically-optimal option, but only if you have the discipline for it.

[bigkid70]

Thanks for all the responses!

@ioseftavi: the debts in question are: cc -25K @ 3.74%, car loan - 5K @ 2.99% (monthly payment = $244 with two years left in the life of the loan). And my e-fund currently isn't enough to cover my spending for 3 months. If I had to cover everything for 3 months, I'd have to use the e-fund plus credit cards.

@plainjane: I have ~$1,200 to throw at debt (at my current level of expenses, I plan on cancelling my cable and seeing about cancelling/revising my cell phone plan soon, which will free up an additional ~$300/mo). My job is pretty secure (I'm a gov't contractor, but the contract/client I support are for a long-term project). The debts and rates are above. As you can see, the rates are comparable, so based on what you said, if I were to use the e-fund money, I would apply it to the cc.

@jack: Like I said to jane, the rates are essentially equivalent, but the balances differ greatly. So, to your comment about motivation, it would seem like paying off the car loan might be more motivating, while also freeing up $250/mo that I could add to my monthly payment on the $25K cc (which I currently typically pay $500/mo on).

[ShoulderThingThatGoesUp]

Those rates aren't that bad. Is the credit card rate going to go up? That seems way lower than most CC debts we see on here.

[bigkid70]

@shoulder: no, that cc rate is locked. I have pretty good credit, and I've had that cc for years. I know it's way lower than most, which is why I've used it for bigger purchases in the past (it's basically the only cc debt I have).

[charis]

Yeah that CC rate is really low.  But I would pay that down first, it's a higher rate with a higher balance.  In your shoes, I might even see if I can refinance the car loan for a lower rate for as much as I can get.  Then you can pay off the CC with the cash on the car loan and work on paying down the one loan.

[bigkid70]

Yeah that CC rate is really low.  But I would pay that down first, it's a higher rate with a higher balance.  In your shoes, I might even see if I can refinance the car loan for a lower rate for as much as I can get.  Then you can pay off the CC with the cash on the car loan and work on paying down the one loan.

@jezebel: I'm not sure I understand your comment. What do you mean by "refinance the loan for as much as I can get"? and "pay off the cc with the cash on the car loan"?

[ioseftavi]

Honestly?  At those rates, I would focus on building your E-fund and maxing your retirement accounts.  Pay the minimums on those accounts, of course, but in terms of "where can your dollars make the biggest impact", you can likely do far better than a return of 3.74% in your retirement account, particularly if you factor in any kind of employer match, and the tax benefits.

I would certainly eventually work on paying off 25k of credit card debt, and I wouldn't want to incur more, but would I prioritize paying it off if it's locked in at 3.74%?  In that case, no. 

[charis]

Yeah that CC rate is really low.  But I would pay that down first, it's a higher rate with a higher balance.  In your shoes, I might even see if I can refinance the car loan for a lower rate for as much as I can get.  Then you can pay off the CC with the cash on the car loan and work on paying down the one loan.

@jezebel: I'm not sure I understand your comment. What do you mean by "refinance the loan for as much as I can get"? and "pay off the cc with the cash on the car loan"?

For example, years ago I had a car loan at my local credit union.  Since we were paying it down quickly, the balance was much lower than the value of the car.  We then had  to make an expensive household heating system replacement.  Instead of depleting our savings or financing through the heating company at a high rate, I refinanced the car loan up to the value of the car, at a much lower rate that we had originally, and used the cash to pay for the heating system.

[bigkid70]

Thanks for the clarification, jezebel. That option doesn't seem practical in my case since it wouldn't allow me to pay off my cc, not to mention the rate on the cc isn't much higher than any expected rate on the re-fi (worst case being the current 2.99%).

Sounds like the best option is to aggressively put money into my 401(k) as ioseftavi suggests.

By the way, thanks ioseftavi. Your comment "you can likely do far better than a return of 3.74% in your retirement account" prompted me to go look at mine. Turns out my company's options for 401's are pretty horrible in terms of returns (my return for the past 12 months was only 2.04%?!). Granted, I've been woefully ignorant to all things 401-related up till now. I just knew maxing out my contribution to reflect whatever my company would match was smart, but I'd never paid too close attention beyond that. Needless to say, that's all about to change...

I'll be moving the large majority of my 401(k) funds to an IRA where I can much better returns.

[ioseftavi]

Sounds like the best option is to aggressively put money into my 401(k) as ioseftavi suggests.

By the way, thanks ioseftavi. Your comment "you can likely do far better than a return of 3.74% in your retirement account" prompted me to go look at mine. Turns out my company's options for 401's are pretty horrible in terms of returns (my return for the past 12 months was only 2.04%?!). Granted, I've been woefully ignorant to all things 401-related up till now. I just knew maxing out my contribution to reflect whatever my company would match was smart, but I'd never paid too close attention beyond that. Needless to say, that's all about to change...

I'll be moving the large majority of my 401(k) funds to an IRA where I can much better returns.

Glad I could help!  Just to zero in on one part of your post:

Turns out my company's options for 401's are pretty horrible in terms of returns (my return for the past 12 months was only 2.04%?!)...

Don't use trailing 12 month returns as a judge of how 'good' your workplace 401(k) is!  That's like deciding lining up 10 different types of cars at a dealership and picking "the best one" based on the highest speed each has attained on the last 2 test drives.  "Highest speed" may not be relevant for what you want to judge, and "last 2 test drives" is too short of a time period.

Similarly with funds in your 401(k).  For example, I've got a Vanguard target retirement fund, and I've done about ~3% or so.  3% is a snooze-fest of a return, but I'm just fine with that - the fund matches my desired asset allocation, with wide diversification, automatically rebalances, and has rock-bottom expenses.  Those are the criteria (not TTM return) that I'd suggest you judge your 401(k) on!

Similarly, don't take a look at your trailing 12 month returns and use that to project what you can realize over the long-term from investing in your 401(k)!  I use a much longer term return for my 401(k) when I'm weighing it against debt payoff, and I figure that 8%, give or take a bit, is my likely-long term return if the next 50 years are anything like the prior 50.

In your case, I'd likely assume similar - figure that you can make 8%, with tax benefits, in your 401(k), vs. 3.74% by paying off the credit card (which comes with no tax benefits).  Will you make 8% in your 401(k) this year, next year, and guaranteed on into the future?  No (and some years, your TTM return will be negative, too!).  But something in the ballpark of 8% is a reasonable guess over the long-haul.

[bigkid70]

Thanks ioseftavi, that all makes sense, except for maybe your comments about yielding ~3% on your Vanguard fund, but then going on to say expect an 8% return over time. Are you saying that your short-term returns are ~3%, but you expect that to average out to 8%?

Also, I was basing my comments (somewhat) on this article I came across: http://www.interest.com/401k/news/kind-return-expect-401k-plans/ . It mentions several Vanguard funds that have average annual 5-yr returns north of 15%. Moreover, of all the funds listed, the only one in my company's plan is the PIMCO total return, which has, by far, the lowest average returns (and the third highest management fees).

That said, after closer inspection of the fund performance in my 401(k), there are many funds that have 16-yr average returns above 7%, two at 10%, and one at around 16%. So, I guess my decision now is whether or not to just re-allocate the money in my 401 to different funds or move about $100K of the available money to an IRA.

[ioseftavi]

Thanks ioseftavi, that all makes sense, except for maybe your comments about yielding ~3% on your Vanguard fund, but then going on to say expect an 8% return over time. Are you saying that your short-term returns are ~3%, but you expect that to average out to 8%?

Exactamundo.  1 year isn't a long time, in the stock market.  In fact, 5 years, isn't a long time in the stock market.  "A long time" in the stock market is multiple up and down cycles.  Over a bunch of periods of booms and corrections, over the long haul, I expect my stock investments to return around 8%.

Think about it: The past 5 years, the S&P 500 has appreciated at something like 13% per year, I think.  While this is wonderful, this has included zero significant down years.  That's not usual, and drawing conclusions from these 5 years is flawed.  In a down cycle (and we don't know when those will happen, how long they'll endure, and how much they'll cost us) - we can probably expect our investments to fall something like 20 - 35%, over that time period.  When you factor these corrections into your average annual return over time, you'll likely get a long-term annual average of somewhere between 8-10% or so (the exact number depends on what 30 or 40 or 50 years you pick).

It mentions several Vanguard funds that have average annual 5-yr returns north of 15%.

I would suggest you check out how those funds did in down years: 1997/8 (asian financial crisis), 2000 - 2002 (dot com collapse), 2007 - 2009 (financial crisis).  If you want to pick the most volatile / riskiest funds, you will make the most in up years.  You will also lose significant money in down years.

You would be better off figuring out an asset allocation / mix of funds that you can live with in up years and down.  If you haven't visited Bogleheads and read their info, that's a good place to start.

[bigkid70]

Thanks again!

I'll check out Bogleheads too.