Author Topic: Next steps for a budding Mustachian?  (Read 3819 times)

¡Pastelillos!

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Next steps for a budding Mustachian?
« on: February 15, 2013, 09:46:02 AM »
First of all:  hello, and thank you all for inspiring me to change my financial life completely.

So here's the situation:  my wife and I discovered this blog last summer and became avowed Mustachians shortly thereafter. We ditched the last of our non-mortgage debt in September and have been ramping up our savings rate ever since (currently at about 42%, planning to get to 50% by the end of next month).

My question is, what do I do with all this money? My wife and I have just over $7,000 saved now, which I know isn't that impressive to most of the badasses reading this, but we're saving an additional $3,000 or so a month at this point so it's growing quickly. The balance of our FHA loan is about $197k, and like I said that's the only debt we have at this point. So what's the best thing to do with the money we're saving? We've been planning on paying down the mortgage enough to refinance and stop paying the PMI (should take about $19k)... is that a good thing to prioritize? What can we do with our cash until then that's better than the savings account it's in now, but still low enough risk to not throw off that plan and flexible enough to take the money back out of when the time comes?

But after that is when it really gets dizzying. Should we pay down the mortgage principal superfast? Invest in stocks? Lending club? REITs? So many options! I could really use just some basic starting-out tips for someone who's never actually had any money before.

Thanks in advance!
« Last Edit: February 15, 2013, 10:07:39 AM by ¡Pastelillos! »

Phoebe

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Re: Next steps for a budding Mustachian?
« Reply #1 on: February 15, 2013, 10:30:20 AM »
Personally I would start paying down your mortgage (at least to get rid of PMI).  To decide if you should go further, it might help to figure out how much you're paying for interest each month.  What really motivates me for long term goals is to create a projection spread sheet.  Then you can see with each additional payment how much your total interest is creeping down.

If you decide not to pay down your mortgage I'd recommend investing in index funds.  They are an easy way to get into it, and it's what our family started with as well (though we had zero debt).  Like all investments they have risk, but they are more diversified than owning individual stocks and they are simpler to choose if you're just beginning investing.  To dip our toe in the water we started investing the same amount on a monthly basis.  It takes timing out of the equation and helps keep you from making decisions based on emotions.

Also, are you maxing out your tax advantaged accounts (i.e. 401k)?

sherr

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Re: Next steps for a budding Mustachian?
« Reply #2 on: February 15, 2013, 11:09:24 AM »
First of all, congratulations on getting out of debt! Welcome to the forums!

A lot depends on what you interest rates on the mortage are and how much you make. If your annual income (after all deductions and everything) puts you the 25% tax bracket or higher (assuming you are in the US) then it is almost certainly better to first maximize the amount of money you put in tax-deferred accounts, like a 401K, Traditional IRA, or HSA. The money you will put into those accounts you will have to invest someplace, so I'll +1 Phoebe's recommendation of starting out with index mutual funds. If you are not in the 25% tax bracket, then you'd probably be better off maxing out any tax-now-but-not-later accounts like a Roth IRA.

Once you've done that the question becomes what to do with the rest: pay off mortgage or invest in a regular account. It really depends on what your mortgage interest rate is, what you expect the stock market to return on average, and how comfortable you are with risk. If you mortgage is at 4% for example, paying extra on the mortgage is saving you money at a 4% rate every year, guaranteed. If you expect the stock market to return 7% on average (which is not at all unreasonable), then it's mathematically superior to invest in the stock market instead of paying off the mortgage. However, stock investments are not guaranteed, so they are inherently riskier than paying off the mortgage. In addition, paying off the mortgage has its own psychological benefits, especially once you own your house outright. So the question becomes not one of what's best but one of which is better for you, it may be worth it to you to loose the extra 3% / year the stock market would give you to reduce your risk and get your house paid off faster. PMI can be annoying, it does not necessarily tip the scales one way or the other in this debate. You'd have to figure out what your "real" mortgage rate is (including PMI) and then see if it's worth it to you to give up the potential stock gains to pay that down.

The best advice I can give is to figure out what you want to do for these first few decisions, go with it, and then as you go spend time learning about investment theory, diversified portfolios, and asset allocation. You will see people discussing these topics all the time on here, and there's no way to know ahead of time which way is best. It's all a circus act of trying to balance investment returns with an acceptable level of risk. Basic advice though is to not leave all of your eggs in one basket. That's what "diversification" is all about. Index funds are a way to own many bits of stocks instead of putting a lot of money in a few stocks, which increases diversification. Investing in a mix of stocks, bonds, REITs, Lending Club, etc. instead of just putting everything in stocks increases diversification across the different kinds of investments you have. The problem of course is that most other forms of investments will not have nearly the returns of stocks / Lending Club, so you have to balance diversification with putting you money where it can actually make more money.

Anyway, I think you should:
1) first take maximum advantage of any tax-advantaged investment accounts you can get
2) decide where to put any extra money: mortgage or additional investments
3) take some time here and there to learn about additional options as you go

Hope this is helpful!

sherr

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Re: Next steps for a budding Mustachian?
« Reply #3 on: February 15, 2013, 11:17:09 AM »
What can we do with our cash until then that's better than the savings account it's in now, but still low enough risk to not throw off that plan and flexible enough to take the money back out of when the time comes?

Oh, I realized I completely skipped this question. If you do decide to refinance to get lower rates / no PMI, then you probably want to keep that money somewhere very similar to a savings account. It's going to be used in the near future so you won't really have time to take advantage of higher interest rates on something like the stock market, and you don't want the volatility of an account like that when you're saving up for a purchase. You can look around, there might be some online-only or local banks or credit unions offering savings / checking accounts that give 3% interest. That's probably about as good as you're going to get for this kind of account. But if you're going to be ready to refinance in ~4 months then you may not even want to bother, the trouble of opening an account transferring the money around may not be worth the few extra dollars you'd get in interest.

¡Pastelillos!

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Re: Next steps for a budding Mustachian?
« Reply #4 on: February 15, 2013, 11:26:34 AM »
First of all, congratulations on getting out of debt! Welcome to the forums!

Thanks!

Quote
A lot depends on what you interest rates on the mortage are and how much you make. If your annual income (after all deductions and everything) puts you the 25% tax bracket or higher (assuming you are in the US) then it is almost certainly better to first maximize the amount of money you put in tax-deferred accounts, like a 401K, Traditional IRA, or HSA. The money you will put into those accounts you will have to invest someplace, so I'll +1 Phoebe's recommendation of starting out with index mutual funds. If you are not in the 25% tax bracket, then you'd probably be better off maxing out any tax-now-but-not-later accounts like a Roth IRA.

It is and we are. I didn't list those among our assets because I'm only talking about general-purpose money here, and we're only thirty so it'll be a long time before the retirement accounts come into play.

Quote
Once you've done that the question becomes what to do with the rest: pay off mortgage or invest in a regular account. It really depends on what your mortgage interest rate is, what you expect the stock market to return on average, and how comfortable you are with risk. If you mortgage is at 4% for example, paying extra on the mortgage is saving you money at a 4% rate every year, guaranteed. If you expect the stock market to return 7% on average (which is not at all unreasonable), then it's mathematically superior to invest in the stock market instead of paying off the mortgage. However, stock investments are not guaranteed, so they are inherently riskier than paying off the mortgage. In addition, paying off the mortgage has its own psychological benefits, especially once you own your house outright. So the question becomes not one of what's best but one of which is better for you, it may be worth it to you to loose the extra 3% / year the stock market would give you to reduce your risk and get your house paid off faster. PMI can be annoying, it does not necessarily tip the scales one way or the other in this debate. You'd have to figure out what your "real" mortgage rate is (including PMI) and then see if it's worth it to you to give up the potential stock gains to pay that down.

Interesting. Our mortgage rate is 4.75%, so it seems like investing might be the way to go, but I hadn't thought to think of it in terms of a "real" mortgage rate with PMI included. Is there a formula for calculating this? Seems like it might be close, which would jibe with my gut's desire to get rid of the PMI at least.

¡Pastelillos!

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Re: Next steps for a budding Mustachian?
« Reply #5 on: February 15, 2013, 11:27:33 AM »
What can we do with our cash until then that's better than the savings account it's in now, but still low enough risk to not throw off that plan and flexible enough to take the money back out of when the time comes?

Oh, I realized I completely skipped this question. If you do decide to refinance to get lower rates / no PMI, then you probably want to keep that money somewhere very similar to a savings account. It's going to be used in the near future so you won't really have time to take advantage of higher interest rates on something like the stock market, and you don't want the volatility of an account like that when you're saving up for a purchase. You can look around, there might be some online-only or local banks or credit unions offering savings / checking accounts that give 3% interest. That's probably about as good as you're going to get for this kind of account. But if you're going to be ready to refinance in ~4 months then you may not even want to bother, the trouble of opening an account transferring the money around may not be worth the few extra dollars you'd get in interest.

Ok, thanks. That's kind of what I figured but I thought I might as well ask.

¡Pastelillos!

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Re: Next steps for a budding Mustachian?
« Reply #6 on: February 15, 2013, 12:25:55 PM »
To dip our toe in the water we started investing the same amount on a monthly basis.  It takes timing out of the equation and helps keep you from making decisions based on emotions.

I really like this idea a lot. Thanks!

Mrs. Pastellilos

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Re: Next steps for a budding Mustachian?
« Reply #7 on: February 15, 2013, 01:35:57 PM »
First of all, congratulations on getting out of debt! Welcome to the forums!

Thanks!

Quote
A lot depends on what you interest rates on the mortage are and how much you make. If your annual income (after all deductions and everything) puts you the 25% tax bracket or higher (assuming you are in the US) then it is almost certainly better to first maximize the amount of money you put in tax-deferred accounts, like a 401K, Traditional IRA, or HSA. The money you will put into those accounts you will have to invest someplace, so I'll +1 Phoebe's recommendation of starting out with index mutual funds. If you are not in the 25% tax bracket, then you'd probably be better off maxing out any tax-now-but-not-later accounts like a Roth IRA.

It is and we are. I didn't list those among our assets because I'm only talking about general-purpose money here, and we're only thirty so it'll be a long time before the retirement accounts come into play.


The wife here. I just want to clarify a bit on this point. We are not maxing out our IRAs or 401ks right now. Mr. P is not contributing to a retirement account of any sort (he didn't have a plan at his job until just recently and we didn't bother to sign up for it). I am, but only 3% (my employer stopped its match, but they occasionally kick in a little bit at the end of the year). Mr. P probably means that we are maxing out any employer match, which we are. Because that match is zero. :/


SunshineGirl

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Re: Next steps for a budding Mustachian?
« Reply #8 on: February 15, 2013, 05:14:16 PM »
Hmmm. You're 30, and you have an extra $3K/month to save/invest. Knowing from experience how incredibly awesome it is to be mortgage-free in your 30s, I would suggest you read up on Vanguard and put your $3K/month there, with the intention of paying off your mortgage when you are able to do so in full. That could be as soon as...5.2 years!! But growing your savings also gives you the option of directing that money toward something else if you want to or need to.

sherr

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Re: Next steps for a budding Mustachian?
« Reply #9 on: February 16, 2013, 09:48:34 AM »
The wife here. I just want to clarify a bit on this point. We are not maxing out our IRAs or 401ks right now. Mr. P is not contributing to a retirement account of any sort (he didn't have a plan at his job until just recently and we didn't bother to sign up for it). I am, but only 3% (my employer stopped its match, but they occasionally kick in a little bit at the end of the year). Mr. P probably means that we are maxing out any employer match, which we are. Because that match is zero. :/

Okay. Well not having an employer match is sad, but I stick by my advice to max those accounts out first before you do anything else. Stock market returns plus a 5-20% extra in reduced taxes (depending on your tax rate in retirement) money should be much larger than either stock market returns or mortgage interest reduction alone. The only downside is that the money is less accessible, you either have to wait till your 59 1/2, use a SEPP plan to avoid paying the early-withdrawal penalty, or just pay the early-withdrawal penalty and use it when you retire early (not the end of the world if you are in a 15% tax bracket or lower when you retire, 10% early withdrawal penalty + ~12% average tax rate is still lower than the marginal 25% rate you would be paying now. Not a *lot* of a bonus over a regular account, but a bonus nonetheless).

Interesting. Our mortgage rate is 4.75%, so it seems like investing might be the way to go, but I hadn't thought to think of it in terms of a "real" mortgage rate with PMI included. Is there a formula for calculating this? Seems like it might be close, which would jibe with my gut's desire to get rid of the PMI at least.

Hmm. Well the amount that you pay in interest each month should be about: Principle * (interest_rate / 12) = Interest
(It's not exactly, because compounding interest monthly that equates to an annual rate of 4.75% is different monthly rate than simply doing 0.0475/12. But it should be close.)

So to work out what your "PMI interest rate" is we must need to substitute your monthly PMI rate in for "Interest" and solve for "interest_rate". Then add the regular interest rate to your "PMI interest rate" and you should have a very good idea of how much your mortgage is actually costing you.

I could easily see people in your position choosing to pay down the mortgage before investing. I might not, but it's just a matter of preference.