How should we prioritize retirement savings, paying down debt, and saving for a house?

Question

My wife and I are newlyweds. We currently have 6 months' emergency fund (3 months are currently in a CD, and 3 months in a high-yield savings account.) We are contributing to get the full match in her 401k. I don't have any retirement accounts available at work.

How should we prioritize our extra money each month? Our only debt is ~$14k left on a government student loan at 6.8% interest.

Here are the options I can think of:

• Pay extra towards the student loan
• Increase our emergency fund
• Put money away for a down payment for a house (we hope to buy in 2-3 years)
• Put money in a Roth IRA (my wife's 401k has really high fees and we will definitely be in a higher tax bracket when we retire, so the Roth seems to be the way to go for extra retirement money after we take advantage of the full 401k match)

Answer 1

It all depends on your priorities, but if it were me I'd work to get rid of that debt as your first priority based on a few factors:

• Government student loans are especially difficult to discharge in bankruptcy, so it is a slightly riskier than average type of debt.
• As I'm sure you know. Getting a 6.8% is almost impossible with low risk. You can get an almost guaranteed 6.8% return on paying down that debt.

I might shift towards the house if you think you can save enough to avoid PMI, as the total savings would probably be more in aggregate if you plan on buying a house anyway with less than 20% down.

Of course, all this is lower priority than funding your retirement at least up to the tax advantaged and/or employer matched maximums, but it sounds like you have that covered.

Answer 2

The advice to pay off near-7% debt is tough to argue against.

That said, I'd project out a few years to understand the home purchase. Will you plan for the 20% down John recommends? The Crazy Truth about PMI can't be ignored. The way the math works, if you put 15% down, the PMI costs you so much, it's nearly like paying 20% interest on that missing 5%. If your answer is that you intend to save for the full downpayment, 20%, and can still knock off the student loan, by all means, go for it.

Edit - I have to question the validity of "we will definitely be in a higher tax bracket when we retire." By definition, pretax deposits save tax at the marginal rate. i.e. If you are in the 25% bracket, a $1000 deposit saves you $250 in tax that year. But, withdrawals come at your average rate, i.e. your tax bill divided by gross income. There's the deductions for itemized deductions or the standard. Then 2 exemptions if you are married. Then the 10% bracket, etc.

Today, a couple grossing $100K may be in the 25% bracket, but their average rate is 12%.

Answer 3

Pay the debt down. Any kind of debt equals risk. No debt equals no risk and a better chance to have that money earn you income down the road once it's invested.

That and you will sleep so much better knowing you have ZERO debt.

You 6 month emergency fund is probably good. Remember to keep it at 6 months living expenses (restaurants don't count as living expenses).