Paid off credit cards. Now what?

November 16, 2006 10:06 AM

What to do with $1200 more a month?

I've looked at the threads about what to do with a lump-sum, but I'm looking for a bit more advice. Having just paid off our credit cards by following a strict budget, my husband and I now have $1200 per month to deal with. We currently put $250 per month into a 5 % APY CD, and about half the maximum into an IRA. We have combined student loans of about $60,000. Mine is based in New Zealand and because I'm living out of country, is racking up 7% interest. His is here in the US, with lower interest, but his principal is around $45,000. What is the best way of using our freed up money? We thought of putting the max amount into the IRA and then trying to get aggressive on my student loan. We have no other debts. Is this sensible? Should we be putting more into savings? (We live in New York City and won't be buying a house anytime soon).

posted by gaspode to Work & Money (23 answers total)

My first reaction would be to pay down loans as fast as possible. Once that's done with, start investing.
posted by craven_morhead at 10:14 AM on November 16, 2006

Best answer: Sounds sensible. Can you imagine what it will feel like to have the student debt gone? Also, if you're using a Roth IRA, I recently read a tip where one way to do things is to contribut the max to a Roth until the principle is enough to pay a big chunk on the loan. Then take the principle out of the Roth (which you can do without a penatly becuase it was an after tax contribution), and anything that you've made in terms of interest gets to stay there and grow tax free. I think the article was in the context of what to do when your loan interest is relatively low, and you think you might make more by investing. I can't seem to find where I read it though.

And hey, give yourselves an extra dinner out each month :)
posted by dpx.mfx at 10:15 AM on November 16, 2006

I assume that 5% CD is your 'emergency fund'? The conventional wisdom is that you should have a couple of months worth of expenses tucked away in case of disaster.

If you do, your plan sounds right to me.
posted by ikkyu2 at 10:19 AM on November 16, 2006

Best answer: Congrats on paying off the CCs! I would agree with (a) fund IRA to the max, (b) put some amount like $100 a month into savings, and let it mount up until you have a month's income in there, as your emergency fund, (c) make the minimum payments on your husband's lower-rate student loan, and (d) put the rest towards your own high-rate student loan. As soon as that is paid off, increase payments on your husband loan. When all the loans are gone, put the entire surplus into the emergency fund and let it build up a home down payment for you.
posted by beagle at 10:20 AM on November 16, 2006

Max out the IRA, make sure you have *six* months of expenses salted away as an emergency fund; then pay down debt, and once debt is paid save and invest.

And good for you for paying off your credit cards and following a budget. Neither one of those things is easy, but life is so much nicer when you're in control of your finances and not the other way around.
posted by enrevanche at 10:29 AM on November 16, 2006

As far as I can tell, by investing rather than paying off your loan ASAP, you've been borrowing money from the NZ government at 7% to invest in the US at 5% return? I'd divert all your money to loans first.
posted by cillit bang at 10:45 AM on November 16, 2006

Congratulations!

Both maxing out your IRA and aggressively paying your student loans are great ideas. Having an emergency fund is also important.

Putting $1000/month towards your student loan balance would pay it off in about 15 months, which is quite soon.

I would suggest that you think about how to balance the financial and the emotional parts of the decision. Depending on how you invest the money in an IRA, it could earn more or less than 7%. You can't know for sure. But the emotional part can be easier to figure out. Do you hate the thought of that student loan debt? Or does the thought of not having enough money when you retire bother you more?
posted by medusa at 10:53 AM on November 16, 2006

When you think about your emergency fund, in a two income household, I would try to be prepared for at least the following:

1) a single party being out of work for six months
2) both parties being out of work for three months

Though it would be reasonable to assume that if the unemployment period is that long, that one might accept temporary underemployment to slow or kill your family burn rate.

If that seems like it is under control, then take care of that 7% debt before you bother investing. It is hard to beat 7%/year after-tax returns on investments, but you can get the same effective result by paying your debt.

If you make (combined) more than $150k/yr you are fucked on the Roth IRA stuff anyway.

Congrats!
posted by Tacos Are Pretty Great at 10:54 AM on November 16, 2006

buy a house and rent it out
posted by matteo at 10:54 AM on November 16, 2006

Just to complicate things for you - New Zealand has some of the most ridiculously high interest rate yields on investments in the first world. For example, just dumping your money into this at call account will yield you 7.35%. If you want to get more adventurous, you can make secure fixed first ranking deposits in companies like this and get 8.5%+ for a fixed term. Also, as an overseas investor, if the issuer is an "Approved Issuer", the tax deductable is something like 2%. For unsecured investments, interest rates often reach 11%+. So after paying US tax on the interest income, it makes the student loan equation rather interesting...
posted by zaebiz at 10:55 AM on November 16, 2006 [1 favorite]

You're getting a lot of good advice here, but just let me add one thing - don't forget take maybe one month's worth, and put it aside to do something special and fun - take a trip, buy that electronic thingy you've always wanted, spa weekend, whatever. Just a one time thing, to be sure, but being on a "strict budget" can be a grind, and if you don't reward yourself for your good behavior every once in a while you may end up resenting it and doing something dumb.

And, congratulations.
posted by anastasiav at 10:57 AM on November 16, 2006

As far as I can tell, by investing rather than paying off your loan ASAP, you've been borrowing money from the NZ government at 7% to invest in the US at 5% return?

You've ignored the exchange rate. For a while, the Kiwibuck was inflating rather aggressively, although the NZ gov seems to have stopped the bleeding.
posted by ikkyu2 at 11:03 AM on November 16, 2006

Response by poster: OK good. Thanks very much everyone. I'm going to mark a couple best to get the check on the front page, but you've all been very helpful.
posted by gaspode at 11:35 AM on November 16, 2006

zaebiz, that's true, but our currency fluctuates through quite a large range relative to the US dollar. It's at 66 US cents today. Within the last year it's been as high as 75, and a few years ago it was barely above 50. The conventional wisdom is that it is still on the high side and should be trading in the low 60s or high 50s.

If the Gaspodes are making the US their permanent home it seems most unwise to go for NZ dollar denominated investments where much, perhaps all of the gain could be eliminated by exchange rate moves. There are a lot of Japanese housewives muttering into their miso about this right now. ("Uridashi" are popular instruments for Japanese people to invest in NZ bonds; many Japanese who did so a year or two ago have just seen all their interest wiped out by exchange rate losses).

Furthermore, NZ finance companies such as Hanover have been going tits-up at a worrying rate recently (eg the ill-fated Provincial Finance), and it emerges that they are poorly regulated, and their already high rates are not enough to compensate for the generally terrible quality of their loan books. In US terms, Hanover's notes are junk bonds, and pretty lousy junk at that. "First ranking secured" means nothing when a finance company goes bankrupt, because they have no assets but their already bad loans. Even the first-ranking creditors will only get cents in the dollar back.

On simple arithmetic you come out best by paying off debt first, as long as the interest rate on the debt is higher than the return on savings. The point of saving before debt repayment is a) psychological - it's hard to wave goodbye to all your cash and b) insurance for emergencies. In your shoes I would focus on eliminating debt once you have an emergency fund.
posted by i_am_joe's_spleen at 11:46 AM on November 16, 2006

The point of saving before debt repayment is a) psychological - it's hard to wave goodbye to all your cash and b) insurance for emergencies

Unless an emergency is extremely likely, only point A applies. After all, if you wipe out $50k of debt and then suddenly need $20k, you can always re-borrow.

As such, it is almost always better to get debt-free before bothering yourself about emergencies.
posted by Tacos Are Pretty Great at 11:52 AM on November 16, 2006

I'd disagree on paying off his student loans ahead of schedule. They're what, 3%? It's not hard at all to find an investment that will make you more than 3%, nor is it easy to find any other sort of loan that will get you anywhere close to 3%.

Get your student loan paid off, and then start investing it.

And Tacos... The point of expensive emergencies (like having to move suddenly because your landlord is turning the building into a home for indigent and superattenuated pickpockets, prostitutes, piemen, panhandlers, and other unworthies starting with the letter P) is that they come up unexpectedly, and having a cash cushion that is immediately available keeps you from having to go BACK into debt, which on top of the emergency, just crushes your soul after working so hard to pay it off.
posted by SpecialK at 12:23 PM on November 16, 2006

"if you wipe out $50k of debt and then suddenly need $20k, you can always re-borrow."

That's not always true. Changing circumstances in your own household or in the wider economy might mean you can't get new credit where once you could, or you can only get it on worse terms, or in a timeframe that's too long.
posted by i_am_joe's_spleen at 12:56 PM on November 16, 2006

joe's spleen : She said her loan is based in NZ which means the differential would be invulnerable to currency fluctuations.
posted by zaebiz at 1:11 PM on November 16, 2006

zaebiz: she's getting paid in US dollars. She'd have to convert to $NZ in order to make an investment there. Just a couple of years ago the Kiwi dollar posted an 18% annual inflation.

If that were to happen again, it's roughly equivalent to taking that monthly$1200 and flushing $200 down the crapper, then trying to beat the return gaspode could have gotten in the U.S.

Also, comparing the enzedd buck to the USD hardly tells the whole story, as the USD has been sliding rather fast relative to the yen and euro for a few years now.
posted by ikkyu2 at 2:52 PM on November 16, 2006

joe's spleen: Think it through bro. She has to convert to NZD to pay off her student loan too.
posted by zaebiz at 3:53 PM on November 16, 2006

zaebiz: ok, that makes sense in her case, strictly because the debt and the putative investment are in the same currency and there's a positive spread between the debt interest rate the investment yield.

However any other readers not living here in NZ should not be tempted, because they aren't in the same situation, and that's worth pointing out.

However I stand by the claim that local high-yield bonds from finance companies are a bad, bad idea. The risk of default on the bonds/debentures/capital notes/fixed structure du jour is very real right now. It's starting with the vehicle finance crowd, because people will lose their cars before they lose their real estate, and because car loans target the worst off, but any downturn from the current boom is going to hit all finance firms hard. The weakest will go under, and because their reports don't reveal the quality of their loan book well, it's hard to tell who the weak really are. Once you restrict yourself to investment grade bonds, or bank deposits (no government guarantees on banks here either!) that spread pretty much vanishes.
posted by i_am_joe's_spleen at 5:33 PM on November 16, 2006

zaebiz: inflation happens over time. If she chooses today to convert USD to $NZ and hold $NZ in a CD, it loses value over time. If she converts USD to $NZ today and pays off her creditors in $NZ today with that money, the creditors are holding $NZ tomorrow and thereafter, and they are left holding the bag, not her.

Let's assume a $1,000 NZ loan balance, a 10% inflation rate, a 5% loan, and an 8% CD. For simplicity let's say today's $NZ/USD rate is .50 and that the USD is not inflating at all.

Option 1: Pay off loan today: costs $500 USD. Opportunity cost of not putting that $500 in a 5% US CD: $25 USD.

Option 2: Do not pay off loan, convert $500 to $NZ, put it in an 8% NZ CD. At year 1 you have:

A loan with a balance of $1050 NZ compounding at 5%. Amount it would take to pay this off in $USD at the 1 year mark: $1025 * (0.45) = $472.50.

An NZ bank CD with a balance of $1080 NZ. Value of this in USD at the 1 year mark: $486.

The risks are that the "first rank" NZ CD at Hanover is going to default and fall apart the way the American S+L's did, which is as far as I can see a nonzero risk. Under the above scenario, you'd do best to invest the $500 in USD, possibly into a Treasury or a CD.

But the above scenario's ridiculous, I freely admit, because the USD will inflate too, and the chance of the disparity between the USD and NZ inflation being 10% is pretty low. If the US dollar inflates more than the NZ dollar does over the next few years, your strategy makes sense.

Here's the way I look at it, though: Investment decisions that could punish me severely for not being able to foretell the world's macroeconomic future (inflation rates, New Zealand bank solvencies, currency exchange rates) are bad decisions to make. Investment decisions, on the other hand, that are "fire and forget" are good decisions, no matter how you arrive at them. And that's why I'm leaning towards option 1.
posted by ikkyu2 at 7:23 PM on November 16, 2006

Er, I typed $1025 above where I meant $1050. $1050 x 0.45 is, in fact, $472.50.
posted by ikkyu2 at 7:26 PM on November 16, 2006