Occasionally I answer reader questions and give them a public financial checkup. The lucky reader gets free advice; you get a peek at somebody else’s money. If you want to be considered for a future checkup and are willing to share your finances with me, learn more here.
Today’s checkup is for “Dan” (29) and “Mary” (25) from Denver. Dan and Mary are married with a six-month old daughter. Both work: Dan as a business development manager and Mary as an accountant. As you’ll see, Dan and Mary are in solid financial shape for their ages, but like all of us, they’re having trouble figuring out that “next step”.
A larger family is at the top of Dan and Mary’s list: Dan says they’d like to have “…a total of four kids within the next five to seven years.” And along with a growing flock, Dan foresees a need for a bigger house.
Dan and Mary also have just over $100,000 in student loans.
Let’s take a look at their complete financial picture and offer some suggestions:
Dan and Mary have a healthy income: Dan earns $85,000 in his role as a business development manager and has the opportunity for a $26,000 bonus if he hits sales goals. Mary earns a combined salary and bonus of $47,000 as an accountant – a job that allows her to work from home (nice!).
Dan obviously has room to boost his earnings by hitting goals at work and negotiating compensation as he proves his performance. With a little one at home and a family as a major goal, I think the key to earning for Dan and Mary will be increasing their value at work and relevant compensation rather than, say, starting a side business. (If you don’t have kids yet, here’s the Cliff’s Notes version: parents do not have free time!)
At the forefront of Dan and Mary’s minds should be whether one of them will want to change their work schedule as their family grows. Either way, the loss of income or the addition of childcare expenses will change their finances dramatically.
Saving and Giving
Despite Dan’s eye-popping student loan balance from his MBA, the couple is off to a strong start. They have about $25,000 in savings, a balance they’ve segregated into $15,000 for an emergency fund and $10,000 for their next house. Given that the couple’s monthly expenses, excluding savings or tithing, are about $4,600, I’d be more comfortable calling the entire $25,000 an emergency fund, as that’s about six months of monthly expenses. The good news is, until they use that money for something else, they have that money in the bank.
Both Dan and Mary take advantage of their employers’ 401(k) matching programs and contribute 5 percent and 6 percent of their gross pay to get the maximum match. Smart move.
Dan also recently started a Roth IRA at Betterment, a site that provides super-simple low cost investing. He’s contributing a bit more than $300 a month. I might suggest he put in the full $5,000 a year if he can. If Dan hits his work bonus, the couple’s combined income of $158,000 will put them close to the Roth IRA’s annual income limit for married couples filing jointly ($173,000 in 2012). So if the couple’s income continues to go up, the Roth IRA won’t be an option forever.
And, not only is the Roth IRA a great retirement saving vehicle, but remember that you can also tap the principal in the account for other reasons (like buying a house) without paying additional taxes or penalties. So in a pinch, it can double as an emergency fund.
Finally, let’s not overlook that the couple is tithing 10 percent of their gross income. That’s a venerable feat. Whether we belong to a church or not, we could all stand to make giving a priority. Although I wouldn’t recommend somebody behind on bills and drowning in credit card debt give away 10 percent of his or her income, once you reach a point of financial stability, putting charity first will not only feel good, it may help you focus how you spend and save the other 90 percent.
Dan also has a total of $1.2 million in term life insurance, which is a great move. With a new family, life insurance means they can all have peace of mind that if something happened to Dan, their financial needs would be covered. I might recommend Mary get some kind of term life policy as well. After all, she contributes income that the family relies upon, and even if she one day decides to stay home as a full-time mom, if something happened to her there would be huge financial consequences. (Imagine outsourcing everything a full-time mom handles: childcare, housekeeping, shopping, and cooking, etc. You’re looking at a big chunk of change!)
The good news is Dan and Mary do not have consumer debt: No credit cards, no auto loans, no home equity lines.
They have an average mortgage on their $150,000 condo at 5.5 percent. It’s an 85 percent loan-to-value (LTV) ratio so they are paying private mortgage insurance (PMI). Now, if Dan hadn’t told me they are already thinking about a bigger home, I would think the couple might be good candidates to refinance. Mortgage rates are considerably lower today and, if Dan and Mary were willing to use some of their cash to refinance at an 80% LTV, they could eliminate the PMI from their monthly payments. Together, the refinance and eliminating PMI would mean a significant drop in their mortgage payment.
That said, refinancing only makes sense if you’re planning on staying put for a while, because you have to recoup the loan closing costs (often several thousands of dollars). If Dan and Mary think they might move in the next five years, I’d suck it up and stick with the current mortgage.
Now to the biggie: the student loans. Most of the couple’s student loan balance is from a now-consolidated $96,500 loan balance for Dan’s MBA at a fixed 6.5 percent APR. Mary also has an undergrad loan at 6.8 percent for $6,600.
As you might know, my (perhaps controversial) advice is that you should not pay off student loans early. Instead, I recommend focusing on saving for emergencies, investing and building your life.
Part of the reason is that you should try to earn an equal-or-greater return on investments over the long run. But another big reason for my advice is that once you put $1,000 towards repaying your student loan, you can’t spend it on something else. That’s gone. Big businesses use leverage – borrowed money – to invest in new opportunities. You can leverage your money to live more life, too — not by borrowing more money, but simply by opting not to repay student loans early.
That’s my spiel. But, in Dan and Mary’s case, Dan writes:
“I feel like a slave to [the debt]. I’ve actually considered moving in to my wife’s parents’ house, renting out our condo and supercharging our pay down on student loans. In this scenario, I’d want to pay them down to $0 before we looked for a new house, of course.”
So despite my advice above, I have a mantra that supersedes it: “Personal finance is personal.”
Moving in with parents for a couple years to wipe out student loans wouldn’t be my first move, but I wouldn’t fault them for it. What I would do, however, is suggest Dan and Mary have several long talks about what that situation would be like, how it would impact their relationships and how that balances with the importance of paying the loans back early.
My Final Advice
As I hinted in an earlier email to Dan, he may be a little disappointed in what I have to say, because it’s basically “keep doing what you’re doing.”
If I were in their shoes I would max out the IRA contributions and continue adding to savings to provide plenty of room for emergencies and also be there if and when a bigger home becomes a possibility.
Thinking ahead to the bigger home and the family to fill it, I would start talking about Mary’s plans for working (or staying home with the kids). Obviously, the decision either not to work or to put kids in daycare will totally change the financial picture. As I wrote about the other day, banks look at the ratio of your monthly debt payments to monthly gross income when deciding to make a loan. So one consideration: if you’re going to apply for another mortgage, that ratio could be harder to make if Mary isn’t working at the time.
I think I’ve said enough, but what would you do if you were in Dan and Mary’s shoes? How do you think they’re doing? Share your opinion in the comments.