Author Topic: Reader Case Study/Question: Optimizing Debt Payoff & Retirement Savings Strategy  (Read 6222 times)

wintertell

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Hi all -- I've been focused on paying down debt, but am starting to think I need to adjust my strategy to a more balanced approach between debt payoff and retirement savings. What approach would you take and why?

Current Debts (86,126):
Mortgage (5.4%): 16,351
Federal Student Loan (5.16%): 20,997         
Private Student Loan (3.59% Variable): 41,290     
Truck Loan (1.99%): 7,488
In 2015, we put 34% towards debt (calculated off of gross salary)

Current Retirement Savings:
Me: 4% into a 401K at work, 4% match
HB: 4% into a 401K at work. 10.5% additional. (Yes that's a 262% automatic return)
This works out to be about a 9% savings rate (based off gross salary) for retirement if you count the matches as extra compensation.

Income: 2 earners about 140K/yr combined gross income.
Emergency fund: Live on last month's income + ~2k in targeted spending account that could be tapped for emergencies if needed. Works out to be about a 1 month emergency fund.

Current Strategy:
1. Save into 401K the minimum to get matches.
2. Put all extra money on to the highest interest debt -- our mortgage -- at 5.4%. The mortgage interest is not tax deductible. Also this is on an adjustable rate that will increase to 7+ percent in 2019. Payoff likely in Oct 2016.
3. Put all extra money on to the 5.15% student loan. With the student loan interest deduction, the effective interest rate is 3.86%.  Payoff expected in February 2017??  See here for rational for why the effective interest rate is lower than actual interest rate: http://forum.mrmoneymustache.com/ask-a-mustachian/student-loan-interest-deduction/

This is where we hit a turning point, as we will have paid off all debt with a 5%+ interest rate.

What would you do next, and in what order would you do these things? Would you balance between debt payoff and savings?

Total debt would be about 43K at that point, mixed between the 1.99% car loan and the private student loan at a variable 3.59% (effective interest rate 2.69% because of the student loan interest deduction).

Some options:
- Save up emergency fund to at least 3 months worth of expenses (~12k). Might want to pad even further because considering having kids in the next 18 months. Would need to plan for unpaid leave for maternity leave.
- Pay off truck - gets rid of minimum payment in 1-2 months worth of extra debt repayment but is a very low interest rate. Definition of a quick win.
- Bump up 401K contributions - HB's would have priority as my 401K has a terrible expense ratio of .75%
- Save for a house payment so we can stop living in a mobile home.
- Continue to go full-throttle on debt repayment and be debt free in an additional 15 months.

Any suggestions are welcome!! Please let me know if you have questions / need clarification.
« Last Edit: April 23, 2016, 09:36:15 AM by wintertell »

MDM

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #1 on: April 22, 2016, 03:35:40 PM »
What would you do next, and in what order would you do these things? Would you balance between debt payoff and savings?
With $140K gross income, you could contribute
$36K to 401ks
$5.5K to a tIRA
$5.5K to a Roth IRA
...and, after deducting federal tax, SS, and medicare, still have $71K to pay for food, clothing, shelter, loans, state tax, etc.

See the 'Calculations' tab in the case study spreadsheet to check those numbers, and the 'Investment Order' tab for more on that subject.

wintertell

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #2 on: April 22, 2016, 03:51:03 PM »
What would you do next, and in what order would you do these things? Would you balance between debt payoff and savings?
With $140K gross income, you could contribute
$36K to 401ks
$5.5K to a tIRA
$5.5K to a Roth IRA
...and, after deducting federal tax, SS, and medicare, still have $71K to pay for food, clothing, shelter, loans, state tax, etc.

See the 'Calculations' tab in the case study spreadsheet to check those numbers, and the 'Investment Order' tab for more on that subject.

Thanks MDM for the advice. A couple of follow up questions:
1) Would you follow the scenario until that point (paying down the 5.15%)

2) If you did follow the scenario until the 5.15% is paid, would you max out all retirement accounts before paying down additional debt (the other 2 loans?) or increasing cash emergency fund?

3) If you did max the retirement accounts, what would come next in your opinion?
« Last Edit: April 22, 2016, 03:54:12 PM by wintertell »

MDM

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #3 on: April 22, 2016, 04:15:58 PM »
Thanks MDM for the advice. A couple of follow up questions:
1) Would you follow the scenario until that point (paying down the 5.15%)

2) If you did follow the scenario until the 5.15% is paid, would you max out all retirement accounts before paying down additional debt (the other 2 loans?) or increasing cash emergency fund?

3) If you did max the retirement accounts, what would come next in your opinion?

You really should look at the spreadsheet. ;)

The size of the cash e-fund is up to you.  Good arguments can be make for various sizes, including what you have now.  I'd feel a little better with "several months of annualized expenses" but my definition of "several" could fluctuate....

wintertell

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #4 on: April 22, 2016, 04:29:49 PM »
I did look at the spreadsheet! : ) Trying different opinions on for size to see where I want to settle in terms of e-fund, liquidity, retirement savings and overall debt burden.  For instance, I still think there is a solid argument for still paying off the 5.4% mortgage given the fact that it will jump up to 7.9% and that it is the largest payment, thus reducing cash flow on a monthly basis.


 

MDM

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #5 on: April 22, 2016, 05:03:15 PM »
I did look at the spreadsheet! : ) Trying different opinions on for size to see where I want to settle in terms of e-fund, liquidity, retirement savings and overall debt burden.  For instance, I still think there is a solid argument for still paying off the 5.4% mortgage given the fact that it will jump up to 7.9% and that it is the largest payment, thus reducing cash flow on a monthly basis.
Fair enough.

7.9% would fit in step 2: Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.
5.4% would fit in step 7: Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.

So yes, I'd pay the mortgage before doing any taxable investing (step 8), but until it jumps I'd make sure to maximize the tax-advantaged accounts.  But that's me - it's a close call and YMMV!

SwordGuy

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #6 on: April 22, 2016, 08:52:17 PM »
Know what the really, really good choice is?

And what the really, really good news is?

You already made the right choice.   Whether you pay off all the debt first, or max your 401k/roths and pay off the debt slower, you'll be "just fine".

Given how fast you could pay off the debt it's unlikely it would make that big a difference either way.  And if the market tanked while you were paying off debt, you could always switch over to maximize buying stock.

You're going to make more if you max the 401ks and IRAs with good low fee broad-based index funds.   You'll have less hassle in your daily life if you pay off the debt first.  And you'll get a bit of both benefits (but less of each) if you go half-way and just focus on the house first.

So, would you rather have more money in 30 years, or have more flexibility in your budget in 2 years, or be halfway between those two options?

wintertell

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Re: Case Study: Optimizing Debt Payoff & Retirement Savings Strategy
« Reply #7 on: April 23, 2016, 07:49:00 AM »
So, would you rather have more money in 30 years, or have more flexibility in your budget in 2 years, or be halfway between those two options?

A big goal of ours is to reduce our monthly commitments enough so that we can quit our big city jobs and move back home to NC. So that's been the reason driving our debt paydown -- We're not sure how much our salary would drop, and thus, what monthly income would be available to cover all of our expenses.

We don't want to have "golden handcuffs" -- We want to take the job(s) we want if/when we move, or if the perfect job comes along for one of us and not the other that we aim to live on 1 person's salary as we get settled.

In addition to living in NC in the long term we also want to be financially free. So two goals that are intertwined.
« Last Edit: April 23, 2016, 07:50:32 AM by wintertell »

AmandaS1989

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Hey wintertell. I see you're having the same problem I am. Quick question for you. When you pay off your mobile home are you bringing it to NC? I know you don't own the land it sits on. Have you factored in the costs of transporting the mobile home? My Dad paid $1K back in 1991 to transport the single-wide we had back then just ten miles. I can't imagine what the cost would be to transport from DC to NC. Will you also be purchasing land of your own or finding another lot to rent?

Since you prioritize freedom (ie being debt, or shackle-free) then maybe you could do a 60-40 or 70-30 split to debt-retirement.

wintertell

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We'd sell it and use the proceeds either to pay off more debt or throw it into a savings account or taxable brokerage account. No way I'm paying to transport it! It is still a good bet to pay it off though because we don't know when/if we are going to move.

I've talked about with HB. I think we are going to continue to go full throttle on debt repayment for a while more and to also try to increase our emergency fund.  Not sure when the magical switch point of focusing on investment vs. paying off debt will be. HB said we could talk about it again once we've paid off the mortgage. 

AmandaS1989

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That's cool. You're still contributing something to your retirement so its not like nothing's going towards it while you pay off debt.

SwordGuy

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If you are looking for flexibility and planning to sell the home in the short term, I wouldn't pay off the debt extra fast.  That just ties your money up in something that you can't use until you sell it.   It actually gives you less flexibility.  I would pay off the other debts and invest.

wintertell

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If you are looking for flexibility and planning to sell the home in the short term, I wouldn't pay off the debt extra fast.  That just ties your money up in something that you can't use until you sell it.   It actually gives you less flexibility.  I would pay off the other debts and invest.

We're hoping to pay it off by Sept/October. I don't think we would move for at least two years? Maybe not at all? So that's plenty of time to move on to other debts, pile up an emergency AND still increase retirement savings.

Guess the bottom line is that this discussion made me realized that we have other medium-term goals that come before the long-term goal of financial freedom. And those medium-term goals have a bigger WHY than the long-term goal right now. But they all increase financial security, just from different angles.

So something like this in terms of financial priorities:
1) Aim towards improving cash flow and dumping debt, so that have smaller monthly commitment in order to increase our options, with various goals being: move to NC with its lower cost of living, HB wants to start a business and start a family soon.
2) Be in the financial position so that way we can support our family if needed.
3) Aim towards financial freedom, so that can eliminate the need to work for a living.
« Last Edit: April 25, 2016, 07:18:24 PM by wintertell »

AmandaS1989

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Two years is plenty of time for you. What part of NC are you hoping to settle in? Where you're from originally or somewhere else? What type of business is HB looking to start?

wintertell

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It would be most likely that we would settle somewhere in the RTP area. That's not where we're from originally, but who knows what might happen?

Erinbynight

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Something you might want to consider, is the variable rate on that 41k student loan. My variable rate just went up a percentage, so I am currently paying down my variable rate, even though I have other loans at higher fixed rates. All of my student loans are pretty low...I think the highest is at 5.55, although it is subsidized in deferment as I am going to school part time reimbursed by my job.

wintertell

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We would start to pay the variable loan if its interest rate met or exceed the highest interest rate loan we are paying.

So right now that would be 5.4% because of the mortgage, and then 5.15% when we are paying down the student loan.

The loan was originally at 7.9% so I'm very glad we re-financed.


Erinbynight

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If I were you guys, I would keep doing what you are doing, i.e. paying off the debts as you have them listed from highest to lowest. When you all find out your pregnant, you can switch to savings mode and minimum payments on debts until pregnancy is over and baby and mom are safe. Then, assuming you have three months e.f., and fmla is 90 days, start paying on the debts again. I would not save for a down payment on a house until your debts are paid. Save enough to avoid PMI. Dave Ramsey's advice is always the same on the subject: save while pregnant and mom and baby are fine. Pay off debts first and save to avoid PMI so that buying a home is a blessing and not a curse.

brant08

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Have you looked at refinancing your loans?  We just refi'd hubbys 28k loans from 5.6% and 6.8% to a fixed 3.5% through SoFi.  Not sure if you'd get that rate but I bet you could beat your current rates.  It takes like 15 minutes to do.  And no changes in your tax deductions. 

wintertell

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The 41K loan has already been refinanced from 7.9% to 3.59% through Earnest. We could refinance the 5.15% as well now that I have lower debt: income ratio. Something to consider.

forummm

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The 41K loan has already been refinanced from 7.9% to 3.59% through Earnest. We could refinance the 5.15% as well now that I have lower debt: income ratio. Something to consider.

I would do that. Whether you pay it off early or not, a lower interest rate saves you money as long as you have the loan.

Personally, I would pay the mortgage off before investing anything in taxable. Since it's not tax deductible and it's your biggest payment and the interest rate will go up, you want to get out of that.

If you can refi the student loan to something 3%ish, then you could just make the minimum payments on it while maxing out your tax advantaged accounts. It's tax deductible so your interest rate is very low. And much lower than the immediate tax benefit you get to saving in an IRA or 401k (assuming your income tax rate will be lower when you retire and pull the money out).

So in a few months you could have 2 very manageable student loan payments with a lowish interest rate and a very small low interest car loan, and that's it. And you could be saving a ton in your retirement accounts. When you increase your 401k by $1k, your paycheck only goes down by about $700 because of all the taxes you aren't paying. Your money goes farther when it's not taxed.

wintertell

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I did go back and get a quote from Earnest.

With a $390 payment and 5 year loan term, the rate would be 3.71% variable or 4.93% fixed. 

With a $400 payment, the lowest would be 4.91% fixed rate with a 5 year term.

Switching to a variable rate at the interest rate I have now (5.16% fixed) would get me a 3.80% variable and a payment of $285.

I currently have a $94.75/month payment at 5.16% with all of the federal benefits.

Not sure if switching to the private loan is the best idea as it commits more cash flow per month for a  1.45% interest rate spread. That is a savings of $304.5/year.