By Michael Stratford
Who: Caitlin Killam, 24
Where: Visalia, Cal.
Question: Should I repay my student loans before building savings?
Since graduating from pharmacy school last May, Caitlin has been attempting a balancing act familiar to many recent graduates. She is staring down $120,000 in student debt while also gearing up to buy a house and save for retirement. Fortunately, as a pharmacist for a major retail chain, she’s well compensated, with a salary of more than $100,000.
Caitlin knows this income gives her options most of her contemporaries don’t enjoy. But that doesn’t make managing life a breeze. “I just don’t know what to do with my paychecks,” Caitlin says. “Should I pay off all my loans right away? Or invest some of the money that I have?” Aside from student loans, Caitlin has no debt and has $20,000 in the bank. She’d like a new car, and hopes to move to Hawaii, where her mother lives, and buy a house there in five to ten years.
Those goals require cash. Caitlin’s first step should be to build up her savings and to set aside a rainy-day fund, just in case. Because she has a secure job in a growing field, a six-month reserve fund should be sufficient. Certificates of deposit are her best bet because CDs aren’t easy to spend on a whim. “Having an emergency fund locked up in a CD makes it harder to nibble away at it for items that aren’t really emergencies,” says Andy Tilp, of Trillium Valley Financial Planning, in Sherwood, Ore.
Caitlin would also do well to buy long-term disability insurance. “Right now, her ability to earn a living is her best asset, and it’s important to insure that asset,” says William Stewart, of Rehmann Financial, in Troy, Mich. The cost to guarantee 60% of her salary if she were permanently disabled should be in the range of $300 a month—or less, if she can get a discount through her employer.
About those loans. Because Caitlin has other financial goals, her student loans aren’t a priority. She’s currently paying $1,400 a month on a ten-year repayment plan. If she temporarily extends the term of the debt to 25 years, she’ll lower her monthly payment by as much as 50% and be able to put aside the difference for other purposes.
At her salary, Caitlin should aim to save as much as 25% to 30% of her take-home pay, advises Paul Baumbach, of Mallard Advisors, in Newark, Del. He also advises that she rejigger her student-debt repayment schedule while she saves for a down payment on a house in Hawaii, where real estate is expensive. In addition, Baumbach says, she should contribute the full $17,000 permitted in 2012 to her 401(k) once she is eligible for matching contributions. That will save about $6,300 in state and federal taxes.
Still, the longer the payment period on her student loans, the more interest Caitlin will pay overall. So if she can afford at some point to return to the ten-year schedule, she should try.
The principle remains the same even for young people who earn less than Caitlin: Set up a loan-repayment schedule you can live with so that you maximize your cash flow for living expenses and other purposes. Discipline works for everyone.