Hey! It’s time for a Reader Case Study!

I almost forgot about this cherished category of posts, partly because my MMM contact email address stopped forwarding way back on January 10th. “Ahh, this is relaxing”, I thought, “I guess nobody has any questions for me these days!”.

Mrs. Money Mustache laughed at my naivete. I fixed the forwarding system on the web host, and FLOOD, 100 personal questions and comments came in to engulf me. (My apologies, by the way, to everyone who emailed me during the past two weeks and was ignored).

So it’s time to get back to work and answer some questions. Today’s comes from a US couple with young kids, just getting started in their careers.

Hey MMM – Did it ever occur to you that Mr. Money Mustache and Sherlock Holmes have a lot in common? I just finished the Adventures and Memoirs series and couldn’t help but draw some parallels. Like MMM, Holmes appears to be an early retiree who does the kind of work that interests him most. He doesn’t even have one car, and he pretty much just does whatever the heck he wants to (granted, Holmes is a bachelor), and it happens to reward him financially. But besides that, he’s a detective. And I kind of think of MMM as a debt-fighting detective who goes around sleuthing to stop crimes of financial insanity. THE FACTS

I’m a recovering law student, still looking for a “real” job while working as a law clerk, and she’s a full-time mom who does some contract editing work in the evenings when the kids are sleeping. Until recently, we took in around $2000 a month, and we spent around $2000. Due to some cuts in our spending (like me biking to work, a borrowed bike trailer for other errands, and other applications of fiscally sound principals) we are planning to squirrel away at least $500 a month until I get a job and our income increases dramatically. Also, because we have two kids, we’ll get at least $4000 from Uncle Sam at tax time (Earned Income + Additional Child tax credits). Unfortunately, we’re in the hole as far as net worth goes. No consumer debt, but we have student loans totaling about $52,000. Ouch. In terms of assets, we have about $6,000 in cash, $14,000 in retirement accounts, two cars* we’re going to sell (worth about $2500 apiece), and our actual family car, a recently purchased ’02 Honda Accord (we paid $4000 cash for it). The student loans are currently in a “deferred” status, which means that there are no payments actually due. In addition, most of them are not accruing any interest during deferment. There is one exception: one of the loans, worth $4700, is currently accruing interest even as I write this e-mail at a rate of 6.8%. (The other loans, once the deferment period ends, will accrue at rates ranging from 4.75% to 6.8%.) THE DILEMMA

Our question is whether to pay down the student loans as fast as possible, or try to build up cash as fast as possible so we can be in a better position to buy a house? Of course we are eager to pay off these debts as soon as possible. Although federal student loans in the U.S. have fairly agreeable terms as loans go (like deferment when you become unemployed, income-sensitive repayment, loan forgiveness in certain careers, etc.) it’s still not something we want to keep around in our lives for too long. But we’ve also been interested in setting aside some money each month into a “house fund,” with the idea that we will probably be buying a house at some point in our life, and we really want to have at least 20% to put down on it. Waiting until the student loan is paid off before incurring a mortgage has a sensible ring to it, but at the same time, I’ve been looking into renting vs. buying in some of the areas where I plan to work, and a $200K mortgage at 3% interest would actually come in quite a bit lower in terms of monthly expenses than a comparable rental. Plus there just aren’t many rentals in some of these markets. So let’s say we have $500 to allocate somewhere every month, plus a one-time windfall from the government of about $4000. How much of that would you put towards student loans (especially the one that’s actively accruing interest at this very moment) and how much would you squirrel away into a savings account? Thank you in advance for any thoughts.

MMM Responds:

Dear Sir,

Congratulations! You are on a good path with low expenses, and I’m glad to see so much thought being put into the next step. In your situation, most people would just immediately go out and finance two minivans while simultaneously buying a house with 0% down and furnishing it with credit cards.

The first step is definitely paying off the currently-active student loan. 6.7% is a high interest rate by today’s standards, and you’ll never beat the guaranteed return you get by paying if off right now. Take some of your cash and wipe it out. Hooray!

Your car situation sounds excellent as soon as you sell off the two spares – one car, paid off, reasonably efficient and reliable. No need for improvement there.

Your next step depends on how those student loans shape up. For now, if they are not accruing interest, there is no need to pay them. But as soon as they do, you’ll want them gone, because the interest rates are higher than those you’d incur with a mortgage.

If I were in your situation, once I got a job offer I’d put top priority on finding an apartment or home rental within non-driving distance to work. It can be a low-cost place for now – remember, you currently have a negative net worth which means it’s emergency time rather than luxury time. Pay off the high-interest loans completely and ignore home downpayment savings for now.

If you try to simultaneously save for the house, you’re effectively paying 6.7% interest for the privilege of building up a downpayment in a 0.9% savings account. That’s not good math. Even if you succeed and end up getting a house this way, you’ll then have a mortgage, property taxes, maintenance and upgrade costs, student loan payments, AND a collection of empty rooms that are screaming for furniture, appliances, curtains, bedsheets, and other treats. All with a negative net worth.

On the other hand, if you eliminate the debt FIRST, your wealth will start to climb much more quickly. You’ll save a compounding amount of interest fees each month. Then once the loans are paid off, you’ll drop your monthly costs significantly. During this whole time, you will be living in a small apartment or rental house which will remind you every day of your mission: saving for the house. Because of this, you’ll lead an efficient lifestyle and the 20% downpayment will fly into your bank account very quickly.

With a good downpayment and no other debts, you’ll qualify for a better mortgage with lower rates and a higher ceiling. This will give you both mental and financial leverage when you eventually do your house shopping, which will help you get a great place. You’ll begin your new homeowning life just as your law career starts to take off, allowing you to rapidly amass a life-sustaining ‘stash. This freedom from debt will also help you avoid the Lawyer Trap, where junior staff feel pressured to work ungodly hours to pad a senior partner’s paycheck. With a strong financial position, you’ll have the confidence to call your own shots and spend the right amount of time with your family.

Case closed, and congratulations again!