In this post, I would like to outline a question that I received via email. Someone very close to my demographic wrote back and forth with me, and basically wanted to know how to allocate a sum of money they received from an inheritance. The basics of the request are as follows:
Hi there, was wondering if you could perhaps give me some advice.
My mother passed away in 2005, leaving me with both a 401k inheritance and life insurance. However, the passing was unexpected as I now have a lot of student loan debt that she would have helped me pay back. Regardless, I have come up with an idea that I would like to assure is not a bad move.
Assets: 401k ($125,000) and remaining life insurance ($80,000)
Debts: $90,000 student loans ($4,000 of it Federal), $4,500 credit card
I was looking to not even touch the 401k and begin adding to it once I began my career as a Police Officer in July. I wanted to use the life insurance to pay off the credit cards and federal loans in its entirety, and bring down the private one to $45,000, leaving me with a $15k liquid emergency fund/savings (after living expenses for the remainder of my time in college) This would then be my only debt, manageable at about $300 or so a month, maybe less once I consolidate. I just wanted some input on if this is a good idea, especially with the loan-pay down. Seeing as how the gov loans have a lower rate, I’m not sure if I should use the $4,000 directly in addition to the private pay down while keeping the gov loans open. Please let me know what you think, thank you.
Credit Card: Just one, at a rate of just under 10% (9.8), with a 5k limit (so practically maxed out)
Federal: Not completely positive since they are not due for repayment just yet, but approx. 5.6 since I last checked
Private: Has hovered between 7.6-8% (Since our economy is in shambles, it has been at the lower end for the past several months)
As of now, all student loans are on a 20 year plan. If I choose to consolidate the privates for a lower rate, I have the option of jumping to 30 year.
I would like to begin by saying that this gentlemen has a level head and some good ideas about how to allocate the funds. But I would like to elaborate on the best financial way to attack this issue. Now, if you have been following this personal finance blog, you are aware of my staunch hatred for debt of any kind. However, in some circumstances, carrying some debt can be more beneficial than paying it off. But let’s dive in and break this situation down:
Regarding the 401k Money
I believe that keeping the money in the retirement account is indeed the best use of this money. Without question, breaking into this money would have serious consequences, mainly Uncle Sam taking a gigantic bite out of the money. Plus, with being so young (age 21) and having 38.5 years to go before retirement (assuming he retires at age 59 1/2), and assuming he could average 8% per year in mutual funds, the $125,000 would grow to $2,419,494.28 without any additional payments into the account. That is a pretty solid retirement wouldn’t you say?
So bottom line, I would definitely keep the 401k money in the 401k account. Let it grow tax deferred (or tax free, if it is a Roth IRA).
Allocating the Life Insurance Money
On this point, I would have to recommend a slightly different strategy than the one he outlined in his email. Starting with the easiest decision, I would pay off in its entirety the credit card debt. Beating 10% interest on the stock market or any other kind of moderately risked asset is going to be hard to consistently do. So with regard to the credit card balance, yes, pay it off.
With regard to the federal and private students loans, I have a different suggestion. I believe that the rates you are paying on these loans are too high. I am fairly confident that you can obtain a consolidation loan to get all of your student loans condensed into a single loan, and you can probably get the interest rate down considerably. I consolidated my student loans back in 2003, and have since paid them off completely. At that time, I was able to consolidate at a rate of 3.5%. Now I understand that the market today is a little different, but let me give you a couple of approaches on how to get the best deal on a consolidation loan.
- Check out SallieMae.com, NextStudent.com, and Nelnet.com for rates and information on student loan consolidation.
- Talk to your home owner’s insurance agency and your car insurance agency to see if they have any relationships with student loan consolidation companies. This is how I found Nelnet, and ended up getting a fantastic rate of interest with a 15 year repayment option.
Now, I am suggesting getting a consolidation loan only if you are able to get your financing down to 5% or less APR. I believe if you are able to obtain a rate like this, then you are much better served investing the remaining life insurance money and getting a better rate of return. It basically boils down to this, if you spend 5% for the money you have, but you are making 8% on that money, the your net result is a 3% gain. And with any long standing mutual fund, you should be able to see rates of this nature or higher. Now, if it was my money, I would likely use it to acquire rental properties, as my experience has shown that I can typically pay back my initial investment in 2-3 years, then enjoy a monthly profit of around $200 per property, while only being at risk for $30,000-$50,000 in a mortgage. Now of course, these are properties in my local market, which will be different from market to market. But overall, I see much greater potential in real estate investing than I do in the stock market or other proven markets. Of course, if you really wanted to go all out, you could start a business…
Anyways, these are all suggestions. At the end of the day, you have to decide if you want to carry the weight of a large student loan or not. Even though I had a great rate on my student loan, I made the decision 4 years into repayment to pay off the balance. I leave it to you…
Guys and gals, please keep sending in these great situations, as I love to address specific circumstances and questions. Please leave your feedback below. ‘Til next time…