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Financial Checkup: Starting a Family with Big Student Loans

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 are planning a family despite big student loans.

Earning

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.

Insurance

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!)

Debt

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.

About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. David, this is a great series and the graphic you created to address everyone’s situation is fantastic. Whoever developed that really has a good eye for that sort of thing.

    For Dan and Mary, I would say though that if you really are that serious about eliminating your student loan, and I know what you’re talking about since I’m currently working my way through about $25,000 of my own undergrad debt, I would encourage you to look for ways to get more out of your budget and make each and every dollar intentional so that drastic measures like moving in with your parents aren’t necessary. Like David was saying, it’s all about prioritizing and figuring out where those dollars fit best. My concern for you is that you’ll try to do too much with this great income and end up hitting none of your goals because you couldn’t accomplish them all. If the debt really does feel like an anchor, pay it off as rabidly as possible and curb some of your savings. If it’s something nagging but you really think you need a bigger house, then go for that while keeping loan payments at a minimum. With such a large income you have a lot of great options on the table. By simplifying those and figuring out where you really want to go and then automating your progress, I think you’ll eliminate stress and accomplish your goals faster.

  2. David Weliver says:

    This is a great summary, Aaron, thanks:

    “With such a large income you have a lot of great options on the table. By simplifying those and figuring out where you really want to go and then automating your progress, I think you’ll eliminate stress and accomplish your goals faster.”

    I definitely agree that they’d benefit from picking one goal and focusing on it–if it’s getting rid of the loans, great. If they’re okay paying those over time, then they can focus on saving enough to get the house they want, maybe with a conventional 80/20 mortgage.

  3. Woah! You are making infographics for people now? Too cool! I would suggest they check out ReadyForZero to come up with a debt plan. And manage their total financial picture with Adaptu.

  4. This is an awesome post. We are in a similar situation to Dan and Mary debt-wise, except we make a lot less money! I’m so glad you mentioned having life insurance for Mary. A lot of people don’t get life insurance for the spouse who has less (or no) income, but the death of that spouse generates a lot of expenses that weren’t there before. I know how Dan and Mary feel about the crushing weight of the debt. I don’t blame them for wanting to pay it down more quickly! But, what you are saying about not paying it off right away makes a lot of sense.

  5. This is a very informative post. I was in a similar situation when trying to pay off my credit card debt after I got married. I had to come up with a plan that continued to sock away money into savings, along with pushing funds toward the credit card payments. I unfortunately did not max out my 401k or even have a Roth IRA, but I do both of these things now, so I am feeling a little better about my retirement picture.

  6. I agree with David’s take on their emergency fund. I would also consider that as they grow their family and move to a larger home, they will have more monthly expenses, so a sizable emergency fund is definitely in order. Given their monthly income, the couple shouldn’t have a problem bulking up their savings.

    Considering their take-home pay, I don’t think they need to move in with their parents to repay their student-loan debt. That’s an extreme measure, and theirs isn’t an extreme situation. Since their student-loan debt balance seems to be a real source of anxiety, I would simply try to keep expenses down while paying extra on their student loans–but I’d build up a larger emergency fund first. Good luck, Dan and Mary. Sounds like you’re doing great!

  7. David gave good advice, I would just add that you might want to not contribute to your Roth until after you have done your taxes for the year. If you get a large bonus you could be above the Roth IRA limits, so I would hold the money until after doing my taxes. Also, if you really want to get rid of that debt, I would recommend cutting expenses. I have no idea where you spend your money, but there are always areas we can trim our expenses if it is important enough.

  8. This thread may be dead, but I’m a dad. Give me a break if I don’t get around to reading emails right away. I was surprised at how similar their story is to ours. We can’t quite tithe like Dan and Mary, but it’s a long term goal for us. Great advice on the mortgage. I was considering refinancing since we’ll move in the 6th year of our 5/1 ARM currently at 3.75% but at best we’d break even. Our differences: a little less income, a lot more “good” debt. Med school debt. We’re pretty strict about building up our emergency fund. But the education loans right now are stagnant until the education investment pays off in a bigger paycheck. The bites we do take out of it are filled by the interest on those in forbearance. It’s maddening. But it’s better than ignoring our 401k’s right?

  9. Dan and Mary says:

    Hi all

    This is “Dan and Mary”. Thanks for the incredible comments and advice for our situation. We’ve tried to make financial decisions in a vacuum, on our own, but the advice of others is often much wiser.

    Although our spending on Misc looks high – it’s not actual spending, just a placeholder for everything else that comes up. I’ve found that things always pop up – license plate renewal, hospital co-pay, new tires on car, travel to see family – and this bucket catches all of those variable expenses other than food and fuel. Most months we don’t spend it all, and those are great months when we can sock the extra into savings. It’s just a way for us to be honest with ourselves that those ancillary expenses come up often.

    On the mortgage, I’d love to refi into the 3s. I have a great credit score (800), but the obstacle is the loan-to-value. We’re right around 85% LTV right now, which would force us to get a 2nd mortgage for the extra 5% at a higher rate, pay PMI, or use our emergency fund to pay down the mortgage. I’d rather use extra cash to pay down my 6.8% student loans than to save a point or two on my mortgage.

    I’m taking the group’s advice and looking into 1) a life insurance plan on my wife’s income, 2) eliminating my IRA contribution in exchange for some student loan debt pay down.

    Thanks for the great advice, and thanks, David, for the opportunity to access your blog’s readers. Have a great day!