TMF Money Advisor Q&A
Extra Cash -- What to do?

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By Jkoering
January 14, 2004

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My wife and I have been debating what to do with extra cash we have from month to month, and I was hoping to get a little perspective on the situation.

My situation is this: I have an enormous load of student loan financial debt, topping $100k. The interest rates, however, are mostly low (below 4.00%!), and almost all fixed. The student loans, in turn, helped me get into a well-paid job.

We are basically just setting out, with 2 1/2 years of work experience under by belt. We have finally dug out from underneath consumer debt, and are well on our way to having a "safety" nest egg of 3-6 months of expenses (in a relatively safe mutual fund).

We still, thankfully, have some money left over, however, and are not sure what to do with it. So, what do you think? Should we (1) invest the extra in the stock market, either through mutual funds or stocks, or (2) pay off some of the burdensome debt? Is there another option that I haven't considered?


David Jacobs (TMFDj111) Responds:

We still, thankfully, have some money left over, however, and are not sure what to do with it. Should we (1) invest the extra in the stock market, either through mutual funds or stocks, or (2) pay off some of the burdensome debt? Is there another option that I haven't considered?

From the information you provided in your post, I conclude your most immediate need is for a financial strategy. Your strategy should be shorter (rather than longer), and it should outline your financial needs and wants, and your plans for achieving your goals. Your strategy will include plans for financial windfalls. I think the entire strategy should fit on one typewritten page, and it should be mostly bullets with just enough text to remind you and your family what the bullets stand for.

To develop your strategy, I suggest you go to the TMF Money Advisor home page, read the information on Step 1, Plan Your Finances, and click on the link to Open Planning Tool. Then work your way through the Planning Tool.

I think a lot of people get hung up with this Tool. They seem to think since it's on a computer, it somehow has great authority, and they must answer every question as if they're under oath.

I think the better way to use this tool is with a more flexible approach. If you happen to have accurate numbers then use them, but using ballpark numbers is okay, too, and I think the better way to use this Tool is to use it as a device to trigger questions.

After you complete the Tool and you have a list of questions, then call the Financial Helpline and ask one of the money advisors to help you develop your financial strategy. The money advisors will help you to do the research you need to do to make informed decisions, and they'll help you to do that research efficiently, effectively, and with a minimum of blind alleys.

From your post, you already have nest egg of three to six months EXPENSES. Most financially aware people have an emergency fund between three months EXPENSES and six months GROSS INCOME. Additionally if you're facing a life event (e.g., graduation from school, marriage, birth of a child, purchase of a home, change of job or career, imminent demise of a family member or close friend, etc) you may want to allow your emergency fund to swell towards a year's gross income. You may want to think about increasing your emergency fund.

Most financially aware people consider mortgage debt and student loan debt to be acceptable, and auto loans and consumer debt to be bad. OTOH from your post, you're clearly uncomfortable with your student loan debt. Reducing your student loan debt or retiring that debt entirely could go a long way to contributing to your peace of mind. Increased peace of mind is an intangible asset that many people find more valuable than more concrete assets.

In your post you didn't mention retirement planning. Many people ignore retirement planning at their peril.

To enjoy a comfortable, timely, secure retirement, most investors must save at least 15% of their gross incomes every year starting in their early 20s. Investors who start late, want to retire early, or want to retire in luxury must save more. If you look through posts on TMF's retirement discussion boards, you'll discover many TMF subscribers claim to save 25% of their annual gross incomes, and a few claim to save over 50% of their annual gross incomes -- in addition to what they save for houses, cars, vacations, and other immediate needs.

I know many people figure they'll save for retirement when they start making serious money or when they get closer to retirement. If you have a financial calculator or a spreadsheet, try this demonstration. First calculate the effect of saving $2,000 per year every year from your 18th birthday for eight years at 8% per year, and then never saving another penny until you're 65, but allowing your savings to compound. Then calculate the effect of saving $2,000 per year starting from your 26th birthday until you're 65, again allowing your savings to compound at 8% per year. Compare the total amount invested ($2,000 per year times eight years vs. $2,000 per year times 39 years) and the final values of the two portfolios at age 65. If this demonstration doesn't convince you to save early and often, I have no idea what will.

Here's a link to an article that contains the results of a similar calculation in a table (click on the link to Rich Man, Poor Man (The Power of Compounding)). The difference between my demonstration and the demonstration in the article is the article uses a 10% annual return (rather than 8%), and the article saves for seven years (rather than eight years).

Some people argue in retirement your income needs are less than when you're working. You're not saving for retirement anymore. You're not paying Social Security or Medicare taxes. Your children probably are on their own. Your requirements for a business wardrobe are substantially reduced. You probably can get by with one car, rather than a motor pool.

However, in retirement, your medical expenses almost certainly will be higher. You'll probably want to spoil your children or grandchildren. You'll probably want to enjoy some of the things you denied yourself while you were working (e.g., frequent meals at restaurants and exotic vacations). You may even take up one of those hobbies notorious for consuming money (e.g., chasing a small, white ball across the countryside or trying to outwit an eight pound, 12-inch fish).

Investors can safely withdraw about 4% per year from a well-performing, well-balanced investment portfolio without cannibalizing their principal. They can withdraw a little more in years with good returns, and a little less in years with poor returns. Lower withdrawal rates are better, and much lower withdrawal rates are much better.

Another way to look at that 4% number is you must have 25 times your gross annual income in savings to retire. You can retire with less money, but you'll have to cannibalize your principal, reduce your standard of living, or reduce your expected lifetime to do it.

Retirement income needs and the timing of those needs vary from person to person, but when you do the research and crunch the numbers, you'll probably discover you have to max your 401(k)/403(b), max your IRA (and spousal IRA), and still make additional retirement investments in non-retirement accounts.

David Jacobs

This exchange occurred on the TMF Money Advisor Q & A board. TMF Money Advisor is The Motley Fool's premier financial planning service. Learn more about TMF Money Advisor or take a 30-day free trial today.