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I am 32 and work in the non-profit sector making 30k/yr. I own my home, which was recently appraised at 202k. I was given an inheritance of 50k from my grandmother. Based on my financials, how should I use this money - pay off debt, save, invest, etc?

Debt:

  • Amount left on mortgage $127k @4.25%

  • Amount left on student loans $29k @2.8%

Savings:

  • Roth IRA $38k

  • Emergency fund/general savings $19k

Thank you so much for your advice.

  • 4
    did you already make your 2014 contribution to the Roth IRA? – mhoran_psprep Dec 2 '14 at 4:06
  • What was the original loan balance and start date for each? – explunit Dec 2 '14 at 17:50
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    @Elle do you have access to a 403b from your employer? – fontophilic Dec 3 '14 at 17:07
7

I would first get rid of the student loan. This will leave you with 11K. I would then use this to fund your ROTH. If you are married you can put up to 5K per year each.

For any money left over, I would open a regular (not tax advantaged) mutual fund. You can contribute half the money you were paying toward your student loans, and the other half can go to your mortgage.

Also I would look at doing a refi on your house. You might be able to move a 10 or 15 year at your current mortgage payment.

  • 4
    Exactly. By paying off the student loan, OP will free up that entire payment to add to the mortgage, to the retirement savings, etc. If OP applies the whole inheritance to the mortgage, she will still have both a mortgage payment and a student loan payment. Optimizing interest payments does not build wealth as effectively as eliminating interest payments. – Kent A. Mar 17 '15 at 5:10
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I wouldn't recommend paying off the debts. Both are low-interest tax-deductible loans that you've been handling well enough to have significant savings, and you can likely earn a higher interest rate by investing than you could by paying down the debt. Putting your money into vanguard ETFs or a betterment account will likely be better in the long run.

  • 1
    Basically - your mortgage isn't just debt, it's leverage. You're taking illiquid money out of your house and putting it into a liquid asset that will likely gain in value faster than your house will at the cost of the interest rate. – David Rice Dec 8 '14 at 18:30
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    This is the option that is most likely of the above options to give you the most wealth in the long run. It is slightly risker if you were to say lose your job for an extended period during a market crash. If your job is fairly stable though this is the best long term option. – rhaskett Dec 9 '14 at 21:36
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    Yeah - I wouldn't have recommended this if she didn't have an emergency fund of 6 months already. – David Rice Dec 9 '14 at 21:43
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    Especially, maxing out Roth/401(k) first is almost free money as it lowers tax liability and would really tip the balance toward investing the cash. – rhaskett Dec 9 '14 at 21:52
  • @rhaskett How does a contribution to a Roth IRA reduce tax liability? – Eric Mar 18 '15 at 3:25
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When considering whether to pay off the student loan, note that, because you work for a non-profit, some or all of that debt may be forgiven after 10 years under the Public Service Loan Forgiveness Program.

I would also like to be slightly contrarian on the main question. I like having lots of savings and little debt as much as the next person. But, unless you have been planning your life with the expectation that you would receive this bequest, it is a windfall. If you weren't already doing an excellent job of saving for emergencies and retirement, or had a lot of consumer debt, I'd say you should use the money to stabilize your finances before doing anything else. But your finances do seem stable. So take some of the windfall and do something nice with it. Travel to the ancestral home of your late grandmother. Endow a small scholarship in her memory. Buy some small luxury that you could never manage on your own salary. I'm not suggesting you spend it all, but using 20% of it on something otherwise out of reach will give you good memories while still leaving you materially better off.

Saving for the future is important. Paying off debt is important. Enjoying life when you can is also important. Balance is everything.

4

You've got a great emergency fund built up and no credit card debt. That's something to be proud of. If you didn't already have those two things taken care of, that would be your first priority.

If I were in your situation, I would pay off the student loan. Yes, it's a low interest rate, but you've got the opportunity to pay it off completely and eliminate a monthly payment from your life. Take it.

I don't know if you've already contributed to your Roth IRA for this year or not, but I would set aside $11,000 to cover the max contribution to your Roth IRA for this year and next year.

That leaves about $10,000 left. Do you have any money set aside for your next car? If not, allocate most of this money toward your next car. When you need to buy another car, you will be able to pay cash and avoid a car loan.

4

Others have suggested paying off the student loan, mostly for the satisfaction of one less payment, but I suggest you do the math on how much interest you would save by paying early on each of the loans:

  1. You didn't say how many years you've got into each of these loans or what was the original loan balance, but doing some rough guesses (e.g. on http://www.bankrate.com/calculators/mortgages/amortization-calculator.aspx) you could easily be paying $600 per month in interest on your mortgage. If you apply the 50K to the mortgage and jump down a few years in the amortization schedule, now you're paying $475 per month in interest (again these are just guesses because I don't know the full details on your loan). Even though your payment didn't change, that extra $125 is now going toward the principal and thus building your equity & net worth.
  2. Do the same calculation with your student loan balance. How much interest will you be paying for the remainder of the loan and how does that compare with your calculations in step 1 for the mortgage over the same time period?

When you do the calculations I think you'll see why paying toward the debt with the highest interest rate is almost always the best advice.

Whether you can refinance the mortgage to a lower rate is a separate question, but the above calculation would still apply, just with different amortization schedules.

  • 1
    Exactly, why would you pay of a loan @ 2.8% when you have another loan @ 4.25%. Always pay off the higher rate loan first unless penalty fees on early repayment will be higher than the savings from paying the higher rate loan first. – Victor Dec 3 '14 at 4:32
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    One big caveat regarding mortgage first. If the student loan is paid off then the required monthly loan payments will be lower immediately because an entire payment disappears. When you pay off part of the mortgage the improved cash flow happens years in the future. – mhoran_psprep Dec 3 '14 at 13:23
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    @mhoran_psprep Good point, but OP didn't mention any cash flow issues and mentions a reserve of 19K so I'm assuming that's not an issue. – explunit Dec 3 '14 at 14:53
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    Another factor is at play. Student loans are harder/impossible to dismiss in bankruptcy, so they might be considered riskier and worthy of paying off even if the interest rate is lower. – JohnFx Dec 4 '14 at 15:14
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    Mortgage interest also provides a tax break (if you itemize), effectively providing a rate reduction - so keeping the mortgage balance instead of the student loan could actually cost less overall. Depends of course on the exact situation, haven't done the math here but wanted to mention that aspect. – brichins Aug 23 '16 at 17:54
1

You mention only two debts, mortgage and student loan, but you mention $19K in savings, which suggests that you are a saver, and likely do not have other debts.

You did not mention your (net) income and expenses (income statement), but since you have substantial savings, you likely live within your means (income > expenses). Since you mention $38K in retirement, we might conclude you are regularly saving for retirement (are you saving 10% toward retirement)?

You did not mention any medical condition or other debts, that might require a large savings, so I would suggest having 6 months savings ($2.5K x 6 = $15K) but should your net expenses be less, you might reduce this ($2K x 6 = $12K).

You do not mention any investment you might want to make, but since you did not mention any candidate investments, we can assume you have no (specific) investments you find particularly attractive. You did not mention anything you were saving to purchase that you might want to purchase.

You have combined $19K + $50K = $69K savings, and $15K would be a comfortable emergency savings, leaving $54K you could use to reduce mortgage or student loan debt.

The mortgage debt interest @4.5%, is higher, so paying that debt off would be like earning 4.5% guaranteed return on your money, tax-free. At your income, your marginal tax rate is low enough that the mortgage interest deduction (if you do itemize) would not reduce this return much (15% if you itemize).

The student loan debt interest @2.8%, would be like earning 2.8% guaranteed return on your money, tax-free.

Clearly the higher return on your 'investment' in paying off debt would be reducing your mortgage balance (over 50% higher return on investment, compared to the student loan debt).

You did not mention any circumstance that might cause the student loan rate to increase, the mortgage rate to increase, nor did you mention any difficulty making both the mortgage and student loan payments, the amounts of either payment, nor the number of years remaining to pay on either.

Should you need (or desire) to reduce your payments, you could choose to payoff the student loan to eliminate one payment, and thus decrease your expenses. Or you could choose to pay down the mortgage, and refinance (or refactor) the mortgage to obtain a smaller payment. Another strategy (assuming you have had your house for 5-7 years), might be to pay the mortgage down enough to refinance into a 15 year loan, and (assuming you have a good credit score) obtain a lower (3%) rate.

But I am going to suggest you consider a blended approach. Combine the Dave Ramsey Debt Snowball approach with the reduce the interest rate approach. Take the $54K ($57K?) available (after reserving 6 months emergency fund), and split between both. You pay your mortgage down by $27K and your student loan debt down by $27K. Your blended return on investment is (2.8+4.5)/2 = 3.65%, and you have the following

Balance Sheet:

Assets:

  • House $202K
  • Savings $15K
  • Roth $38K

Debts:

  • Mortgage $100K @4.5%
  • Student Loans $2K @2.8%

The next steps would be to,

  • Focus on paying off the student loan and then use the money freed from that payment to payoff your mortgage.
  • Consider refinancing into a 15 year loan for the lower interest rate.
  • Consider whether a slightly smaller emergency fund ($13K) and paying off the remaining student loans ($2K) would leave you with a comfortable emergency fund. (Note that if your student loans are $300/month, the additional depletion of emergency fund would be offset by the reduction in amount of emergency fund needed over 6 months).

There are two great reasons for paying off the student loan debt. One is the Dave Ramsey Debt Snowball approach which is that this is the smaller debt, and thus represents a psychological win, and the other is that student loan debt has special treatment even in bankruptcy.

  • the OP did explain their income at $30k/yr and the amount left on the mortgage is 127k and on the student loan 29k. – warren Dec 4 '14 at 19:49
  • I stand corrected, but the OP did not provide the net income (after taxes, etc), nor their expenses, thus they did not provide a complete picture of their income statement. – ChuckCottrill Dec 4 '14 at 23:17

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