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I am able to save $1,100 a month, after all expenses and after paying the minimums ($225 a month on my 2.24% and 3.25% student loans). I want to make smart decisions with my money, but am not sure what to do. I currently have a secure job and have about $23,000 in these low interest student loans. I have no credit card debt and I have $5,000 in savings. I am single and 22.

Should I: a) use that $1,100 to pay off debt, even though it is at a low interest rate? b) save it in a "high interest" savings account? c) invest it in index funds? d) a combination? e) something else?

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Does single mean that you are living on your own? –  Zephyr Dec 10 '09 at 20:24
    
Nope, I just mean for tax purposes. I actually have a girlfriend (see my response to #6 below...any guesses?) but am living with 3 roommates...it's a crazy apartment, but it's also crazy cheap. Living in Washington, D.C. –  Daniel Dec 10 '09 at 21:14

7 Answers 7

up vote 11 down vote accepted

If you can get a rate of savings that is higher than your debt, you save. If you can't then you pay off your debt. That makes the most of the money you have.

Also to think about: what are you goals? Do you want to own a home, start a family, further your education, move to a new town? All of these you would need to save up for. If you can do these large transactions in cash you will be better off.

If it were me I would do what I think is a parroting of Dave Ramsay's advice

  1. Pay off credit cards and other unsecured debt.
  2. Save up several months of living expenses as cash. Put that in an accessible place and earn a bit on it.
  3. Contribute 100% to a retirement account. (If you start now, you can achieve amazing things when you retire)
  4. Pay off that low interest debt
  5. Invest a little for fun
  6. Save up for a big purchase
  7. Enjoy your extra money.

Congratulations by the way. It isn't easy to do what you have accomplished and you will lead a simpler life if you don't have to worry about money everyday.

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Thank you. I really like your advice, I've been told to pay off all your debt as fast as possible. I'd rather slow down a bit 1. I have no credit card or unsecured debt. 2. I have a ~5,000 emergency fund + a stable job. 3. I contribute 10% to my Roth 401(k) through work. 4. I plan on tripling or quadrupling the monthly payments on the 3.25% loan. 5. I'm planning on throwing $200 a month at investing, which isn't too much but gets me in the game a little. 6. I plan on making a ~$6,000 purchase within the next 10 months. 7. I'm not going to live like a college kid as much. –  Daniel Dec 10 '09 at 20:59
    
@Daniel There are those who would suggest paying the loan as agreed. Chances are you will (in the future) earn better than 3.25%, so much better to invest with extra money than toss it at a loan payment. I personally would pay it off, especially if your retirement is fully funded. I abhor debt and know less about investing. Your call though. You are doing great either way! –  MrChrister Dec 17 '10 at 19:16

Daniel, first of all, I'm jealous of your predicament. That said, I think you've gotten some good advice already, so I won't repeat what's been said. But I will throw out a few ideas that haven't come up. My first thought is that you may be underestimating upcoming expenses. It sounds like your current expenses are low, and that's great! I'm impressed that you're living below your means, and looking for the best way to use your extra cash. But you may not be thinking of a few things.

You have a girlfriend, and maybe your relationship isn't such that you are planning a wedding quite yet. But, regardless of whether your current girlfriend is your future life partner or not, if you think marriage may be in your future at all, you'll save yourself a lot of stress if you've got some savings for a wedding in place before you're ready to commit.

Next, what are you driving? If it's a good car that you expect to last you another 10 years, you're probably ok right now. But if you may need to replace your vehicle in the next few years, start saving now and you may be able to buy it outright. (I expect your interest rate on financing a car would be higher than your current student loan rates, so I would save for a car before paying down loans with such beautiful rates.)

A house has already been discussed, and there was also mention of additional education, and both of those require a solid financial plan that begins far in advance.

In summary, I think you need a lot more than $5K in savings. Sure, have some fun, and take advantage of opportunities to travel, etc, as they come along, but if you're able to bump your savings by $500 to $1000/month, I think you'll really be glad you did. When it comes time for a new car, or you find you're ready to settle down, it will be nice to have somewhere to draw from, and if there's only $5K in your savings, you may come to regret choices you made when you were 22.

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I like the other answers. But, here's one thing that concerns me that hasn't specifically been addressed yet:

You mentioned your student loans are at low rates of interest. Are those rates fixed or variable? If those interest rates are variable, I would not count on rates remaining low indefinitely. If you could imagine those rates going up by say 2% or 4% or more over time, would such rates make you change your mind about the debt and the pace at which you're paying it off?

I would suggest that as the economy recovers over the next couple of years, the spectre of inflation will force the Fed to raise interest rates. You don't want to be holding variable-rate debt when rates are rising. For that reason, if your loan rate is variable, I would increase your payment amount so you can eliminate your debt sooner than later.

Also –

You mention in one of your comments that buying a home is 4+ years away. That's not a long time, so I wouldn't commit the bulk of your savings to investing in the stock market, which can be temperamental over short periods of time. You don't want to be in a large loss position just when it's time to buy your first home.

However, it may be worth having some of your skin in the game, so to speak. Personally, I would take a balanced approach: 1/3 debt repayment, 1/3 high interest cash savings, and 1/3 in some broad diversified index funds – and not all in the U.S. Although, I also like the idea of getting some travel in while young, so perhaps 1/4 allocations to the money stuff, and 1/4 towards travel? :-)

Good luck.

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Great point about the loans, they are variable, and I am sure they will go up over the next two years at some point. Until the economy recovers a little, they won't however, so why not have money in the stock market at least until then? Right now, I am planning on doing all of the above: debt repayment, savings, index funds, and some fun while I'm young. As for the house, I don't have any plans yet, that's not even close to being on my radar, that's what i meant by 4+. I have no clue where I'll be or what I'll be doing. –  Daniel Dec 11 '09 at 4:01
    
@Daniel: "Until the economy recovers... have money in the stock market until then". It strikes me as odd to have money in stocks until a recovery happens. During the recovery is when you'll want to be in stocks. If a recovery strengthens, causing stocks and interest rates to go up, you won't want to sell your stocks that are going up to pay off your loans. –  David Oneill Feb 9 '11 at 16:55
    
Also, you can't reasonably expect a 3% return on the stock market in a 2-3 year time span. Overall, stocks are great, but only in the looooong run. That means that the expected 2-3 year return of stocks will be lower than the expected return of paying off your debt. –  Lagerbaer Jan 4 '13 at 16:27

In your situation I suggest:

  • Not paying off the student loan any faster (it's a very low interest rate)
  • Save up more than $5k in a savings account (rainy day money)
  • Invest in anything with matching or tax deductions, like employer matching or tax sheltered retirement funds. That's all free money, so get as much as you can.
  • If you are planning to buy a house, you will need to save even more (savings account) for a down payment. If you could ever get to 20% or 25% downpayment (very hard on the first home) you should qualify for lower mortgage insurance premiums.
  • Outside of that, mutual funds are ok if you're careful about MER, etc.

In terms of what to spend it on, one tax preparer I knew said he would ask his wealthy clients (ones with real net worth) what they spent their money on, and it was almost always travel. We agree, memories from our trips are ones that last a lifetime. I can't say much else you buy gives you the same long term payback in your personal life.

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I like that, and am planning on spending some of my money on experiences. Guilt free, even if I go over my "budget." I have no matching contributions but I do have a Roth 401(k) and while buying a home seems 4+ years away, I will have to save up. So basically I'll take your advice, invest a few hundred a month, save 600 a month, and spend a few hundred on travelling and having some fun. –  Daniel Dec 10 '09 at 23:46
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I love the travel advice. Everybody finds happiness in their own way, but I still remember my early 20's as the time I could have the most fun. –  MrChrister Dec 11 '09 at 7:12

Excellent responses so far. Because I am a math guy, I wanted to stress the power of compounding.

It's great that you are thinking about saving and your future when you are so young. Definitely be displined about your saving and investing. You would be surprised how just a small amount can compound over the years.

For example, if you were to start with $5000 and contribute $100 per month. Assuming that you can get 5% ROR (hard in today's world but shouldn't be down the road), your final principal after 28 years (when you are 50 years old) will be over $90,000, which of only $38,000 is what you contributed yourself. The rest is interest. You can play with the numbers here:

http://www.math.com/students/calculators/source/compound.htm

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Yah, I've played around with a lot of these calculators. Right now it's easy for me to envision saving $5,000+ for the next several years (until I make more money and up my contributions) but I also know that there will be things to derail me (marriage, a house, more student loans). I just hope I can keep up my $5,000 a year investment for the next few years. –  Daniel Dec 17 '09 at 15:54
    
the only number you should be concerned about is 0.Put all your extra money on this loan and before you know it,it will be paid off.It's hard to put a dollar value on feeling good about having no debt. –  Tim Jun 14 '10 at 1:49

Since you already have an emergency fund in place, focus your extra funds on paying off debts like student loans. While some have advised you to play the stock market, not one person has mentioned the word "risk". You are gambling ("investing") your money in the hopes your money will grow. Your student loan is real liability. The longer you keep the loan, the more interest you will pay. You can pay off your student loan in 21 months if you pay $1,100 each month.

After the 21 months, you can almost fully fund a 401(k) each year. That will be amazing at your age. Our company gives us the Vanguard Retirement Fund with a low expense ratio of 0.19%. It is passive automated investing where you don't have to think about it. Just add money and just let it ride.

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Hey guys, I wanted to thank you for all of your answers, I honestly can't choose one that I thought was far better than the others. I think I will definitely take all of them into consideration. I will continue to save and only invest a little, just so I get in the habit, but I am also planning on spending my money to have some fun. I just booked a ticket to LA for New Year's to with my girlfriend for the weekend/her birthday. It was expensive, but worth it I think. If I won't spend my money on things I want, what's the point of having it? Having said that, I've also made a strong effort to pay for part of the trip using bonus money I get for referrals at work. For a few minutes of work asking people to call and get a free quote for car insurance, I get $15. And most of the time, my friends get lower, rates, so it's a win for everyone! (If you're interested in helping me out and getting a great rate, let me know lol!)

Again, I appreciate all of your suggestions and I voted for each of them!

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You're welcome! (BTW, a tip for the future: You can click "edit" under your question and add a paragraph, e.g. "UPDATE: ...", instead of answering your own question to provide an update.) –  Chris W. Rea Dec 14 '09 at 21:12

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