Question: I'm 29 years old, married, and we don't have kids yet. I recently graduated from college with $61,200 in student loans. My partner and I both work full time and together make Gross $90-95,000 a year. We are renting but are hoping to buy a home in the next year with the VA loan.
I recently got a second income from a contract position that will last a year (12 months exactly). I will make an extra $1,750-$2,350 after taxes monthly starting in November.
We want to put this money towards the student loans. However, I don’t need to make payments until May 2025. I have government subsidized and unsubsidized loans. So half of these loans won’t be accruing interest until then. About 4 of my loans are also under the SAVE plan so they also won’t be accruing interest until then.
My question is which option should I choose?
I pay the student loans every time I get paid (biweekly).
I Invest all the money until May (6 months) and then make one big payment. If there are even any investments that would be worth doing this for a 6 month period. After 6 months I would probably make around $12,500.
I pay the minimum monthly payment from our regular money starting in pay while investing all the apprenticeship money for a whole year. Afterwards I used the around $25,000 + investment to make one big payment.
I’ve never invested. So if option 2 or 3 is best could you give me some recommendations on what investments or savings accounts I should use.
Answer: Evaluating Your Options for Managing Extra Income and Student Loans
Congratulations on your recent graduation and on securing additional income through your contract position. It's commendable that you're proactively considering how best to utilize this extra money. Let's analyze each of your options to help you make an informed decision.
Option 1: Pay the Student Loans Every Time You Get Paid (Biweekly)
Pros:
- Reduces Principal Early: Making payments now lowers your loan principal before interest starts accruing in May 2025.
- Habit Formation: Regular payments can help establish a disciplined repayment routine.
- Improved Debt-to-Income Ratio (DTI): Reducing your student loan balance may positively impact your DTI, which could be beneficial when applying for a mortgage.
- Psychological Benefit: Seeing your debt decrease can provide a sense of accomplishment and reduce financial stress.
Cons:
- No Immediate Interest Savings: Since your loans aren't accruing interest until May 2025, early payments don't save on interest right now.
- Opportunity Cost: You might miss out on potential investment earnings by not investing the extra funds.
- Liquidity Reduction: Paying down loans reduces your cash reserves, which might be needed for home-buying expenses.
Option 2: Invest All the Money Until May (6 Months) and Then Make a Lump Sum Payment
Pros:
- Potential Investment Returns: Investing could yield returns, increasing the amount you can put toward your loans.
- Liquidity: Keeping the funds accessible allows flexibility in case unexpected expenses arise.
- Maximizes Use of Grace Period: You can benefit from the non-accrual period on your loans while your money works for you.
Cons:
- Market Risk: Short-term investments may not yield significant returns and could even result in losses, especially in volatile markets.
- Minimal Interest Earnings: Safe, short-term investment vehicles typically offer lower returns that might not significantly increase your lump sum.
- Potential Impact on Mortgage Approval: Having higher outstanding debt when applying for a mortgage could affect loan terms or approval.
Option 3: Pay the Minimum Monthly Payment While Investing the Extra Income for a Whole Year
Pros:
- Extended Investment Period: A longer investment horizon might increase potential returns.
- Cash Flow Management: Paying the minimum keeps your monthly obligations lower, providing more flexibility.
- Accumulated Lump Sum: You could make a significant dent in your student loans after a year.
Cons:
- Increased Exposure to Market Risk: More time in the market doesn't guarantee returns and can expose you to potential losses.
- Interest Accrual Begins: After May 2025, interest will start accruing on your loans, potentially offsetting investment gains.
- Impact on Home Purchase Plans: Carrying higher debt could negatively affect your DTI ratio, influencing mortgage approval and interest rates.
Additional Considerations
Impact on Home Purchase
- Debt-to-Income Ratio: Lenders consider your DTI when approving mortgages. Reducing your student loan balance can improve your DTI.
- Credit Score: Consistent payments can positively impact your credit score. However, large outstanding debts may negatively affect it.
- Cash Reserves: Lenders also look at your savings. Having liquid assets can strengthen your mortgage application.
Interest Rates and Loan Types
- Subsidized vs. Unsubsidized Loans: Focus on unsubsidized loans first if they are accruing interest.
- SAVE Plan Loans: Since these loans aren't accruing interest until May 2025, prioritizing them may not be urgent.
Recommendations
Based on your goals and the factors above, here's a suggested approach:
1. Prioritize Unsubsidized Loans That May Be Accruing Interest
- Early Payments: If any of your unsubsidized loans are currently accruing interest, paying them down first can save you money.
- Interest Savings: Reducing principal on these loans lowers the amount of interest that will accrue over time.
2. Build or Maintain an Emergency Fund
- Financial Cushion: Ensure you have 3-6 months of living expenses saved.
- Home Buying Expenses: Allocate funds for down payment, closing costs, moving expenses, and potential repairs.
3. Use Safe, Short-Term Investment Vehicles
Since your investment horizon is short (6-12 months), consider low-risk options:
- High-Yield Savings Accounts:
- Pros: FDIC insured, easy access, competitive interest rates.
- Examples: Online banks like Ally Bank, Marcus by Goldman Sachs, or Capital One 360.
- Certificates of Deposit (CDs):
- Pros: Fixed interest rates, FDIC insured.
- Cons: Funds are locked in until maturity (ensure the term aligns with when you'll need the money).
- Treasury Bills (T-Bills):
- Pros: Backed by the U.S. government, terms from a few days to one year.
- Cons: Generally low returns but very safe.
4. Balance Debt Repayment and Savings
- Hybrid Approach: Consider splitting your extra income between paying down loans and saving/investing.
- Example: Allocate 50% to student loans and 50% to a high-yield savings account.
- Flexibility: This allows you to reduce debt while also building savings for your home purchase.
5. Avoid High-Risk Investments
- Stock Market Volatility: Investing in stocks or mutual funds is generally not advisable for short-term goals due to potential volatility.
- Focus on Capital Preservation: Prioritize keeping your principal safe over seeking high returns.
Steps to Implement Your Decision
Review Loan Details:
- Interest Rates: Identify which loans are accruing interest.
- Loan Balances: Note the amounts to prioritize repayment.
Set Up Automatic Payments:
- Consistency: Ensures payments are made on time, positively affecting your credit score.
- Biweekly Payments: Can slightly reduce interest over the life of the loan.
Open a High-Yield Savings Account:
- Shop Around: Compare interest rates and account features.
- FDIC Insured: Ensure the bank is FDIC insured for protection.
Monitor Your Progress:
- Regular Check-Ins: Review your loan balances and savings monthly.
- Adjust as Needed: Be flexible and adjust your allocations if circumstances change.
Prepare for Mortgage Application:
- Check Credit Reports: Ensure there are no errors affecting your credit score.
- Gather Financial Documents: Pay stubs, bank statements, and tax returns will be needed.
Final Thoughts
Given your goal to purchase a home within the next year, maintaining a strong financial profile is crucial. A balanced approach that reduces your debt while building savings for homeownership expenses may serve you best.
- Stay Informed: Keep up-to-date with any changes in student loan policies or mortgage lending standards.