Ask the Blogger

02.19.13

How to Save it and Where

Saving vs. debt repayment, index funds v. ETFs, and why they don't turn Camp Pendleton over to developers?

Dear Blogger:

I write to ask your opinion on where to divide $2000 per month of disposable income between emergency savings, retirement, school loans, college savings for my son, and my own school loans. I'm a 34-year-old man, and this March, I will pay off my consumer debt, completing a financial turnaround that took me from the brink of bankruptcy in January 2011. Since then, I've settled $15,000 in credit card debt for about $6,000; short sold my severely underwater house in Detroit; and paid off about $25,000 in other, mostly unsecured, debt. This leaves only my school loans ($145,000 from law school at 6.8–7.9%, and $20,000 from undergrad at 4.25%). This took some discipline, and landing a job at a law firm didn't hurt.

After paying bills and other commitments (such as child support), I have about $2000 per month left over. I have about $4300 in emergency savings, and I estimate that I need $2000 per month to live comfortably and continue to pay child support. I have $2600 in my 401(k), and I'm putting in $1700 per year because I feel I need to put at least something in there. I have not opened a 529 plan for my son, but I plan to do so soon, and I'll probably add some token amount (like with my 401(k)) until I get my student loans paid off.

I've stretched the $20,000 undergrad loans over 20 years—at 4.25%, those loans don't need to be sucking up cash that I could put toward the law-school loans. I'm making graduated payments (currently $1200 per month) on my seven law-school loans (totaling $145,000). I plan to overpay on one loan at a time, resulting in progressively lower monthly payments as I knock off loans the minimum payments of which then get rolled into the overpayment. I make too much money to deduct my school-loan interest.

So, I ask the Blogger: How should I divide $2000 per month among these obligations?

Sincerely,

Treading Water, But Not Drowning


Dear TWBND:

First of all, congratulations. Pulling yourself back from the brink of bankruptcy, and getting all your consumer debt paid off in less than two years, is a major achievement. If no one else has patted you on the back for your discipline and sacrifice, allow me to be the first.

Now, onto savings and debt.

If you had a smaller amount of debt, I’d tell you to put it all towards those student loans. You’re unlikely to get a risk-free return of 7-8% anywhere else.

But at $2,000 a month it will take you almost five years to pay off your loans. That’s too long to forgo the benefits of tax-advantaged savings for college and retirement. It’s also too long to be coasting with such a light emergency fund.

Your first priority should be to get that emergency fund built up. If you try to do anything else first, an emergency could end up wrecking it. If you get sick or lose your job, you’ll drain that $4300 pretty quickly, and then you’ll be tapping your 401(k) at hideous expense in taxes and penalties, and going back into consumer debt. So this is number one.

You need a minimum of 6 months of unavoidable expenses—a year if your job is unsteady. (I don’t need to tell you what the economic climate is for lawyers right now). Beef that up to the point where you can ride out a significant crisis. “Unavoidable expenses” means things you have to pay, no matter what: any debt minimums, child support, rent, utilities, grocery money, and insurance payments. It does not include eating out, cable, or a cleaning service. I’m sure you know this already, but I just like to make sure.

Once you’ve established a really solid emergency fund, it’s time to start thinking savings and debt reduction. Luckily, the tax benefit is going to help us stretch that $2000 farther. We’re going to put $1000 a month in your 401(k), which should qualify you for any match. But because of the tax advantage, that’s only going to be taking $700-800 out of your paycheck.

Similarly, we’ll put $500 a month in a 529 educational savings plan.  That leaves us with $700-800 for additional debt reduction. Here you’ve got the right idea: pay extra on the smallest loan, and when you pay it off, roll that payment into the extra payment on the next smallest.

Using that strategy—and assuming no raises--in ten years you’ll have an ESA with something north of $60,000. Even assuming no employer match and a modest return, you’ll have about $200,000 in your 401(k). And you’ll have paid off all your law school debt, leaving you with an extra $3,000 a month to plow into some combination of higher savings and fun.

Like a lot of law-school grads, you have a tough hill to climb with all this debt. But you’ve already proven that you have what it takes to do it.


Dear Blogger:

I have recently inherited a sum of money. Not enough to retire instantly to somewhere warm and beachy, but a pleasant increment to my nest egg. We already have the basics covered: we pay off credit cards every month, mortgage is paid off, college fund is topped up, emergency fund is sufficient, retirement fund is comfortable. So this is money for which I have no pressing need. I am looking to invest it with a time horizon of ten or fifteen years.

I'm not a big fan of active money managers; I don't think I have a better than average chance of picking one who will beat the market. So, I'm happy to play for average returns and low fees. This leads me to index funds and ETFs. What's the difference, and why would I choose one over the other? Thanks.

Sitting On A Nest Egg Until It Hatches


Dear SOANEUIH:

Let me start by thanking you for not making me explain, once again, why it is folly to invest in actively managed mutual funds. Your own research, and undoubtedly a soupcon of inborn perspicacity, have already revealed to you what all economists know and most investors don’t: you can’t beat the market, so it’s better not to try. Whether you choose an index fund or an ETF, you will be investing in about the same broad index of stocks, rather than naively chasing elusive higher returns down dark and narrow alleys.

However, this makes your decision either harder, or easier. Harder because while the differences between mutual funds and exchange traded funds are large, the difference between index funds and index ETFs are not. Many of the advantages that ETFs offer, like lower fees, are also offered by index funds. Others, like the ability to get into very narrow specialty products, are “advantages” that you have sensibly eschewed.

ETFs also allow you to invest without a minimum account balance, which is good for investors with small amounts of capital. But while you don’t say how big your nest egg is, I assume it passes the threshold of any index fund you might be interested in.

So that leaves us with the tax advantages. This money sounds like it’s going to be in an ordinary account, instead of a tax-advantaged account like an SEP or a 401(k). That means that you will be liable for capital gains on distributions. An index fund does minimize these sorts of tax consequences compared to an actively managed fund, but ETFs give you much more control over the timing of losses and gains.

However, this is about timing, not avoiding the taxes forever; you’ll still have to pay when you liquidate the ETF in 10 or 15 years. And unless you have a much more complicated financial life than you’ve described, you’re not going to get much benefit out of timing gains and losses.

So what makes the decision hard—the differences are subtle—also makes it kind of easy. The truth is, it doesn’t matter that much. Pick a good firm who won’t, say, get your funds mixed up with the ones it’s supposed to wire to JP Morgan right before it goes bankrupt. Shop around for the lowest fees. Then put the money away and forget about it until you’re ready to use it.



Dear Blogger:

If you've ever driven from LA to San Diego, you know that you have to drive through for about 20 miles along the pacific coast shore in what is currently Camp Pendleton.

Camp Pendelton is huge - over 200 square miles. Geographically, it's about the size of Chicago - except that it's located in beautiful southern california where the weather is unbeatable and real estate is extremely expensive.

I can appreciate that our marines must have someplace to train... even someplace on the ocean. But how can this be the highest use for this property? It is, quite literally, located in one of the most valuable places in the country. This is not federal woodland in Alaska or remote Utah. It's oceanview property. Lord only knows what its worth...

Shouldn't we (as a country) be trying to move this property? If you absolutely must have ocean-side property for training purposes, do you really need 20 miles? And even if you do, why aren't you selling this land and using eminent domain to purchase oceanfront land someplace less valuable like the Gulf Coast or Atlantic... or just about anywhere really.

Puzzled at Pendleton


Dear PAP:

Probably you are thinking that you would enjoy the opportunity to buy a house with a lovely ocean view on the Pacific, and that this would be a higher valued use than having Marines jog along it. You know who also enjoys expansive ocean views? The people who are stationed at Camp Pendleton. And they know more Congressmen than you do.

But that’s not exactly fair. The United States military presumably does need some bases that satisfy the following three criteria:

1) They are in the United States
2) They are on the Pacific
3) The water stays clear of ice in the winter

Unfortunately, those three criteria are also very popular with homeowners; hence the seeming paradox of a military base located on prime oceanfront views.

To know whether Camp Pendleton should be moved, we need to know what the alternative is. Is there somewhere else that the government could put an oceanfront training facility? Even if we relaxed the requirement of putting it on the Pacific, are there similarly large parcels of land along the Atlantic that are warm enough for the marines to conduct amphibious training in the winter? Would acquiring such a parcel and building all new facilities be cheaper than keeping the one they have?

The Atlantic beachfront that meets these criteria is often similarly valuable, and it would take years or even decades to acquire enough land via eminent domain. So it seems likely that the folks at Pendleton will keep their views until such time as we no longer need to train marines in the art of taking beaches.



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