Ask me anything #3rd edition
By glblguy
Photo by: star5112
Each week I give the readers of Gather Little by Little a chance to ask me anything. The only real rule is that I can decline to answer. I’ll do my best to answer as many questions as I can though. Have a question you would like answered? Just drop me a line or leave a comment!
I received two questions since last weeks Ask me Anything post. The first questions is from Emily who wrote:
I have a question about the best way to pay-off a very large debt and save money at the same time. My husband just graduated from his doctoral program and is about to start his new job. For the past year and a half we’ve been living-off of a $50,000 loan. After we move for his job, we’ll have barely any money left from this loan, and thus no savings. This is a personal loan from my parents with a low interest rate (around 3%) that we can pretty much pay back how we want.
I’m confused about how we should tackle this debt since it’s so large and the interest rate is so low. Should we pay it in small increments over a period of about 15 years so that we can build savings, save for a down payment on a house, and start a college fund for our kids? Should we devote all of our extra funds toward knocking it out and ignore other saving needs for about 5-7 years? (probably the earliest we could pay it off with our salary) I’d appreciate any thoughts on this!!!!! Thanks!
Emily, the first thing I would recommend that you do is build up a comfortable emergency fund. Since it’s just the two of you, $1000 should be sufficient. Once you have the $1000 safely stored in a separate savings account you need to start tackling your debt. The best way to do this is using a debt snowball. It’s hotly debated on whether you should organize your debts by interest rate (highest first) or by balance (lowest first), but choose which one you feel most comfortable with. Personally, I like paying off the lowest balance first as it gives you that emotional high of knocking out your debt.
While the interest rate on your loan is low, it’s a family loan. Family loans can cause some really ugly situations, so personally I’d tackle that one first. I wouldn’t even consider purchasing a house while you’re paying off your debt. I’d put everything you can towards it, and just get it gone. Look for opportunities to create some extra income and use that money to pay even more on your debt (often called snowflaking).
Our next question is from David who has a very similar question:
Question: Is it better to build up your savings OR pay off dept?
Situation: We have $16,200.00 in savings and a $16,100.00 pay off on our truck.
Monthly payment on truck is $375.00. We have been able to pay off all credit
card dept effective June 15th! YEA!My thought is: Pay off truck, use $375 per month to rebuild savings.
IF something where to happen before savings was built back up.
We can sell off truck, that we would now OWN in case of emergency
Which would leave us with only house and operational dept, lights, food etc.
once truck was paid off.My wife’s thought is: Keep paying monthly on the truck. Keep building up
savings as we have been so we have funds in case of emergency. Payoff on truck
is 5 years out.Note: I am the main bread winner and my job is considered unstable. We have had
several lay-offs with more to come.Thanks in advance
David
David, different people are going to give you different answers, but since I am allergic to debt, I’ll always say pay off debt. Whenever you have debt, you’re paying interest. With today’s savings rates, you’re paying more on a loan than you would be earning in a savings account. Debt is also a dark cloud that follows you around, and if anything bad ever happens in your life that debt can cause you a great deal of trouble.
Here is what I would do. I’d sell the truck and use the money to pay cash for a nice inexpensive used car or truck (with gas prices the way they are, a car might be a better option). Take what’s remaining and add it to your savings.
Now, that’s all assuming you aren’t in the hole on your truck, if you are, than again I would sell it, and use your savings money to pay the difference. Then use a reasonable amount of your savings to again buy an inexpensive used car or truck.
I was in a very similar situation, $300.00 per month truck payment. I sold my truck, used the equity to buy a used 2001 Nissan Sentra and took the rest an applied it against my credit card debt.
Since you feel like your job is fairly unstable, you’re going to need that savings just in case you lose your job, so I wouldn’t recommend using it all to pay off your truck. Selling your truck and getting rid of that truck payment (and associated debt) would free up even more money to save even faster.
Readers, what would you suggest Emily and David do? Anyone have alternative advice? Remeber, if you have a questoin you’ed like to ask either about me or about a personal finance situation you may have, just add a comment or drop me a line.
June 26th, 2008 at 7:17 am
For the folks with the truck, if they’re not willing to sell it right away, I’d say pay most of it off but still keep a few thousand in emergency savings.
$1 to $2k can make a world of a difference if something pops up, and you’d want a cushion if you NEEDED to sell your truck so you wouldn’t have to sell it to the first person to give you an offer.
Plus, his wife would probably sleep better at night knowing there was an emergency cushion.
I’d say aim to have the truck paid for in six months.
Then, in six month’s time, you’ll be $2250 in regular payments closer to paying it off ($375 x 6) and you won’t have to completely exhaust your emergency savings.
June 26th, 2008 at 8:34 am
If this was a loan from a bank of some other third party, I’d say pay it off as slowly as possible, because the interest rate is so low. However, this being a low interest loan from a family member, I would advise to pay this one off as soon as you can. $50,000 at 3% is about 5% lower than you can get for a student loan. This comes to about $2,500 a year that his parents are giving you.
Now it was and is their decision to give this to you, and I assume they are not clamoring for their money back. However if you make a good effort to pay them back as soon as you possibly can, it will forstall possible problems with them, or with your siblings, in the future.
Think about it. You go out and buy a new car for $25,000. Your parents think ‘Nice car I’m paying for.’ You go on a $10,000 vacation. Your brother thinks ‘I’d go on a vacation too if I borrowed $50,000 and didn’t have to pay it back anytime soon.’ This is a potentially very bad situation I’d advise to get out of ASAP.
Take it from one who learned the hard way, money has a way of changing a relationship, even between parent and son. Show them you value their money and give it back to them.
June 26th, 2008 at 10:48 am
I thought your advice was good in both situations, and I would agree with your assesment.
June 26th, 2008 at 11:04 am
For David ….
I would absolutely NOT pay off the truck if you are the main bread winner with an unstable job. If you lose your job then you are going to have a serious cash flow problem and will not be able to borrow money. That cash flow problem could force you into a firesale situtation that will do more damage.
I don’t know how much money you need to live for 6 months without a job but it will be much more than a starter emergency fund.
If you are really worried about your job and want to be proactive then replacing the truck with a more affordable choice is a good suggestion.
If it makes sense to you to keep the truck now … then if you lose your job later you can bite the bullet and downgrade the truck at that time. You will have the savings to avoid the cash flow problems.
BTW, if you had a stable job then I would have suggested paying most of the truck loan off.
The most important thing is for you to stay focused and make smart decisions (instead of luxury purchases) during this time.
Good luck :)
June 26th, 2008 at 11:39 am
Emily,
The low interest rate should not be a factor in how you handle this loan.
I too don’t like family loans just because those relationships are so important and money disagreements can easily destroy them.
However, I also would hate to see you rent for so long. I’m assuming 5-7 years to pay off the loan and then you have to save for a down payment.
If your family is ok with a 15 year payoff then I would set that schedule up and make that at a minimum EVERY month. Let that be the standard expectation which you can exceed (see below).
I would then live well below my means and aggressively build up savings for a downpayment on a home.
Then periodically (maybe once a year) I would take a portion of that years savings and make a bonus payment on the loan. Lets say you saved $10,000 this year then pay your family $5,000 extra. That will go a long way to showing them that you are not only meeting your obligations but are exceeding them. Also, let them know you are saving for the downpayment.
As long as you are spending wisely (living below your means) then I think the family loan will be fine. You may even find that they encourage you to not make extra payments in liu of saving for the down payment. Let the relationship guide your decisions at that point instead of the interest rate.
Never ever allow the family member to feel like they are being taken advantage of. They are rewarded with a feeling pride when they can help you and they know it was appreciated and respected.
June 26th, 2008 at 2:34 pm
For David, my suggestion would be to take some savings and put it towards the truck. That way you could reduce the time you’re paying interest by shortening the life of the loan, but you still have savings.
Being the primary bread-winner with an unstable job, I think it would be a very bad idea to wipe out your savings. That’s a huge risk. I agree with RobY that if you had a stable job it would be okay to pay off most of the truck loan, but right now, in my humble opinion, having a finanical safety net is more important.
June 27th, 2008 at 5:54 pm
Thanks for the advice, everyone! The loan is from my parents who are extremely generous in their giving. When we got pregnant halfway through my husband’s schooling and I had to quit my job, they refused to even let us look at federal loans because they didn’t want us to have to deal with that kind of interest rate and obligation. (we didn’t ask for this, they offered and kinda talked us into it) They didn’t even want to charge us interest at all, but we found-out that there must be a minimum charged or it could affect their taxes badly. I know as long as we make regular payments, they don’t really care how long it takes, and I can’t imagine it ever being an issue in our relationship. (they probably would have just given the money to us if they weren’t aware that that probably wouldn’t be healthy for our long-term financial independence). Maybe we’ll try for middle-ground, somewhere around 10 years. Thanks so much for the advice, I appreciate hearing other opinions on our situation!
May 15th, 2010 at 5:40 am
Your point is very positive.