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.

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%.

I read this Q&A again and would add one more observation - Student Loans and Your First Mortgage is an article I wrote in response to a friend's similar question. With the OP having plan to buy a house, paying off the loan may be more costly in the long run. It may keep him from qualifying for the size mortgage he needs, or from having enough money to put 20% down, as I noted earlier.

With finance, there are very few issues that are simply black and white. It's important to understand all aspects of one's finances to make any decision. Even if thee faster payoff is the right thing, it's not a slam-dunk, the other points should be considered.

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).