I am currently trying to decide the best way to allocate my savings, and I would appreciate your input. I am trying to budget roughly based on the idea of using 50% of my post tax income for necessities, 30% for discretionary income, and 20% for savings. In this instance, I am ending up with a savings rate of about 26%, with some potential for more depending on lifestyle adjustments.

Currently I am saving by contributing to my 401k, adding to an emergency fund (and then, after a certain amount, allocating that cash to investments), and servicing existing student loan debt. I am currently paying more than the minimum on the student loan debt, meaning I could theoretically pay less. Currently they are fairly low APR, averaging around 4.5% fixed, which seems to indicate I would likely do better invested in the market.

Furthermore, I could also obviously reduce my allocations to my 401k, but right now I have it set up to get my full match. I am fairly recent out of college, so retirement is a long ways off. Finally, I intend to save most or all of my end of year bonus in cash or investments (not guaranteed, but firm is doing very well as of now).

Currently, I am allocating roughly 50% of my savings to cash or cash equivalents, 30% to student loans, and 20% to my 401k. My medium term goal is to buy property. Buying property confers benefits like no longer having to pay rent, building equity instead, etc. However, I need a downpayment to do so.

With all of that background, here are my more specific questions:

  1. I recently moved and drained most of my emergency fund because of related expenses. Now, I mostly only have assets in the market. Should I reduce 401k contributions, student loan payments, or both, to increase cash savings until I get more of a buffer?
  2. Should I prioritize saving / investing cash in general over student loans? There's a small possibility of some federal loan forgiveness, and even if it is unlikely, it feels remiss to prioritize paying those off right now in the event that some or all of them could simply be forgiven.
  3. Should I make lower contributions to my 401k to increase cash / investment savings? This theoretically could leave money on the table, but there is a 3 year cliff vest, and it is not incredibly likely that I will be at my current job in that time horizon.

Thanks in advance.

3 Answers 3

  1. If at all possible, I'd put enough into my 401k to get the maximum company match. I don't know what the rules are at your company, but typically the company will match 50% or 100% of what the employee puts in up to some limit. So every dollar you put into a 401k gets an instant, guaranteed 50% to 100% profit. I've never heard of any investment that competes with that. I'd put money into a 401k before I put into any other savings or investment. Except, I suppose, to build up a minimum emergency fund.

  2. My next priority would be building a reasonable emergency fund. And let me say here, I've heard advice on how much you should have in an emergency fund that I think is wildly unrealistic, like "six months gross pay". When I was young, I didn't put anywhere near that much into my emergency fund. I read one explanation for this saying that you need enough to maintain your lifestyle if you lose your job. Well if I lost my job, (a) It probably wouldn't take me 6 months to find another job. The one time I did get fired, it took me 2 months to get another job. Maybe if you're in a field where it's tougher to find a new job a bigger emergency fund would be called for. (b) Why gross pay and not net? If I'm living off my savings, I don't have to pay taxes when I withdraw money from my savings. (c) If I lost my job, I wouldn't blithely continue to spend at the same rate as when I had a steady income. Thus, I think 2 months net pay would be plenty for most people to survive a brief period of unemployment.

What I've really used my emergency fund for in real life has been things like unexpected car repairs, a big medical bill, that sort of thing. In that case comparing to your income isn't the key point, but rather coming up with a plausible amount for likely unexpected expenses. These days I'd probably say $2000 or so.

  1. Balancing between investing and paying off debts is a complicated question. The stock market typically gives bigger returns than the interest on most debt. So if, say, you have a debt at 5% and the stock market is growing at 7%, mathematically it makes sense to put any extra money in the stock market, and, in principle, collect 7%, use 5% to pay the interest on the debt, and keep the 2% difference. (Of course you probably wouldn't actually withdraw from your investments to pay the interest on a debt while paying the principle on the debt from other income. But in principle you could.)

If you have a debt with higher interest than any available investment, like credit cards, I'd pay those off before adding to investments.

But when the interest on the debt is smaller ... Another way to look at it is, interest on a debt is usually a fixed amount, while investment returns are highly variable. On the average for the past few decades, the stock market has returned 7%. But it certainly has not returned a predictable 7% every year. One year it may go up 15% and the next year down 10%. It's a roller coaster. So it comes down to deciding on average returns versus your tolerance for risk. You may have practical or psychological reasons why you're not willing to take a high risk.

There's also the practicality that it's just convenient if you can pay off a debt. It's one less bill to deal with every month. Getting rid of the bill simplifies your budgeting and eliminates the possibility that you'll make a mistake and forget to pay the bill and get hit with late charges, or have some other problem. Like personally, I have my mortgage down to the point where I owe just $10,000. So I've reduced how much I add to investments and am putting that money toward paying off the mortgage, so I can get it paid off in the next few months and just get rid of it.

In my humble opinion, paying off a student loan would be about the last thing on my priority list. Pay the minimum, of course. But student loans tend to have low interest rates. And, I don't know the terms of your loan, but there are often clauses in the contract that if your income is low you qualify for reduced payments, so these are less of a burden if you did lose your job or some such. Student loans are often extinguished when you die. So if you add $1 to a retirement account, that's money you can leave to your heirs. If you pay off $1 of your student loan, that does nothing to increase the value of your estate, because the debt would be wiped out when you die anyway. Of course all of this depends on the terms of your student loan, but it's worth looking into.

  1. I keep almost nothing in cash. I typically keep about $3000 in my checking account, and that's probably way too much. I want to keep enough in there so that if I make a mistake I don't accidentally overdraw the account. That's about it. $1,000 is probably plenty for that.

I keep my emergency fund / slush money in a set of very conservative mutual funds. I talked to a broker when I set this up and said I wanted a fund that was unlikely to lose more than 1% in bad years, and of course I understood that that meant it probably didn't make that much in good years. He found me a couple of funds that had rarely lost more than 1% and generally gained maybe 3 or 4%. I considered that perfect. I call this my "savings account" and that's how I think of it. I drained that account when my daughter went to college and then once when it was my turn to bail out my sister.

  1. In practice these days I use a credit card as my real emergency fund. If I have, say, a car or home repair, I pay with a credit card, and then when the bill comes, instead of adding to my investments I use the money to pay off the credit card. I make enough money these days that it's very rare for me to have to leave a balance on a credit card. For people with tighter finances, having a good emergency fund is more important.

It sounds to me like you have your budget and asset allocation figured out. Do what makes you feel comfortable and I'm sure you would be fine. If it were me, this is what I would do with your current accounts.

Emergency Fund - Since you drained your emergency fund, you need to build it back up so you need to prioritize saving money. It is recommended to have 3-6 months of EXPENSES (not salary) saved up. By your math you have 50% necessity and saving 26% (I assume that doesn't include your 401k contributions) which means you should have 3 months saved up in 6 months (or sooner depending on your current balance). You can also cut corners in your discretionary income to build it up faster. Once you hit 3 months it is up to you how much more you want to save and where you want to cut corners, but save until you you have have a good cushion.

401(k) - Even though you have vesting period of 3 years and don't see yourself at the company for that long, I wouldn't bring down your 401k contribution. If you do stay at your current job longer than you expected (because life happens), you are missing out on free money. So keep your contribution at the minimum match.

Student Loans - I would bring down your student loan contribution to the minimum and put the rest into your savings account. You need to build up your emergency fund again before putting it back towards low interest debt. A 4.5% fixed interest rate is pretty close to free money, so you don't have to worry about paying tons of money on interest (unlike credit cards).


Somewhat dissenting opinion from the other two answers.

Investing is hard at the moment since interests rate are extremely low and the stock market is quite a bit overvalued. For example Research Affiliates puts the 10 year expected real return (after inflation) for US large cap stocks at -0.5% and for US Core at -0.3% https://www.researchaffiliates.com/. Yes, these are negative numbers. While the stock market has been doing historically much better it may take a long time from today to get back into 5%-7% range.

If you believe this assessment (Which is always tricky business), your correct action would be.

  1. Contribute enough to your 401k to get the full employer match. That's free money.
  2. Rebuild your emergency fund to 3-6 months of living expenses. Go towards the high end if you want to build up some savings for a down payment on a property.
  3. Then consider paying off your student loan or maxing out the 401k. That decision depends a bit on your incremental tax rate since the main gain of the 401k contribution is tax avoidance (or deferment). If in doubt split it 50/50.
  4. Do whatever you didn't do in step 3
  5. Do NOT invest into anything else until your student loans are paid off.
  6. Consider throttling down the 401k (to the match level) to save for a down payment

4.5% interest on the student loan doesn't sound like much but at the current investment climate that's a really good rate of return and it's zero risk. It also helps building credit rating and it's nice to be debt free. 30 year mortgage rates are currently at 2.5% or so. Ultimately you want your debt at this rate, not lower.

CAVEAT: The current administration considers new regulations around Student Loan Forgiveness. It's hard to predict how this will play out and who may or may not be eligible for it. It may be prudent to track this carefully and keep at least $10,000 of debt around until this has played out.

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