Saving Money or Paying Off Your Debt First – Money Mailbox

by David Ning · 11 comments

Sometimes, going against conventional wisdom can work out in your favor.
Emile writes:

I stumble on your website after a Google search and what a pleasure it was. I have a situation and I’d appreciate your honest opinion on it. I am graduating college in about a month with about $30,000 in credit card debt and student loans. I’ll be starting a job in June paying $72k/year. I was thinking of paying off all my debt during my 1st year.

Doing this would mean minimal savings. Do you think it is a good idea? FYI: I have about 20k in student loan and 10k in credit card.

Many people will tell you to build an emergency fund first, but I will tell you otherwise, as soon as you feel comfortable in saying that you are safe at your current position.

But First, Congratulations

It’s great that you are finding a job.

  • Especially in this economy.
  • Especially straight out of college, and
  • Especially at such a good pay.

For those still looking to find work, there’s hope. But let’s get back on track, your question about your debt.

Pay Off the Debt First

Everyone has touted the benefits of an emergency fund, but I see your situation a little differently as a fresh graduate. Emergency funds are for times to tide people over in cases where income vanishes (ie, lost of job). But as a young individual, you likely never had long term full time employment and you manage to live all these years.

Also, your expenses are likely still low, and choosing to build an emergency fund and leaving your debt is only likely going to speed up the rate you inflate your lifestyle.

Since you can make significant progress towards your debt repayment in a very short amount of time, the best approach, I feel, is to pay off your debt first.

Like you said, you will have minimal savings for a while, but being debt free and starting clean will help you build a much better foundation for the future. This is also why I didn’t ask how low your interest was on your student loans. It’s at $20k, and while it’s a sizable amount, it’s not for someone like yourself who earns $72k and can make significant more as you progress through your career. Pay it off first gives you a better chance to learn better money management skills, so the benefits outweigh the fact that you may be able to hang on to low interest debt and invest it for a higher return.

To help you pay them off, here are 25 tips to pay off your debt.

Some Alternatives

If you truly want to build a small savings first, remember that you are now eligible for a 401k as well as a Roth IRA. The 401k match, if your company provides it (and you are eligible right away), is like free money. Take advantage of that if you can first, though I feel that paying off your debt first and not having much savings will help boost your appreciation for money during the first year, and ultimately help you more down the road than a couple years of company matches.

Secondly, when you think about where to put your savings, you may want to contribute to a Roth IRA instead. Contributions to a Roth IRA can be withdrawn at any time without penalty, so it actually acts as a good way to build an emergency fund. Just remember that while contributions can be withdrawn penalty free, earnings are a different story. If you decide to go this route, note the rules and make sure you know how much you can withdraw before you work out the numbers.

Reality Check

Note that it will be hard to pay off $30k worth of debt in the first year. When you get your paycheck, you will realize that all the taxes, unemployment insurances, medicare, social security etc will eat into a big chunk of your paycheck. Depending on where you live, it could be as much as 30% or even 35% less than your negotiated salary. Add on the interest that your $30k will accumulate in the first year, and you are probably looking at needing a little more than one year to pay off your debt.

Then again. Just focus on paying it off aggressively, and whether it takes 12 or 13 months is a relatively minor point since you have your whole life ahead of you.

Which Debt to Pay Off First

Your credit card debt is small and carry a higher interest so this one is easy – pay that off first and just pay the minimum on the student loans. Once the credit card debt is gone, you can work on your student loans at full force.

Usually, I will advise people to consolidate their debt (especially credit card debt) to a lower rate using either Lending Club, or those 0% balance transfer credit cards to save on interest. However, again, since you can repay your debt relatively quickly and you are starting out in your career. I think it’s better to just stick with the high interest, and instead focus your time on developing good money habits by reading sites like this one and skills for your career.

Do What Works for You

As you can see, what my suggestions are may not always be conventional, nor are they purely based on mathematics. Think about what the reasons why I’m recommending what I’m suggesting, and do what you feel is best for you. When you are behind an idea, you can make it work even if it’s not the best. Good luck.

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{ 11 comments… read them below or add one }

GoYanks April 16, 2010 at 7:35 am

My suggestion –
Step 1. Payoff CC
Step 2. Start contributing to 401k to get company match
Step 3. Payoff student loan while contributing to 401 enough to get full company match
Step 4. Once student loan is paid off, put extra savings in Roth IRA or 401k

Going forward, try to increase your 401k contribution by a couple of percentages every year when you get raises until you hit the IRS limit.

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marci357 April 16, 2010 at 7:58 am

Doing the math – there will be about $48000-$50000/yr after taxes – estimate. That’s about $4000/month take home. If you can live on under $1000/month (like me) that’s $3000/month towards debt. But more realistically for most people, you’ll live on $2000/month and have $2000 to pay off debt.
So somewhere in those ranges you’ll have between $24,000 and $36,000 to go towards debt. So yes, if you’re really strict, you could have it all paid off in a year.
But, as stated above, whether it takes 12 months or 15 months, you’re getting it paid off soon – that’s the point.

I agree with the wisdom above.
1. Pay off the credit card fully first. Highest interest (one supposes) and will free up cash flow.
2. Contribute fully for matching employer funds if 401K. If not, contribute to Roth or traditional IRA, as your tax man advises. The taxes you pay for the year will be lessened with the traditional IRA and that may free up more $$ to pay the debt off with. You cannot make up these early IRA or 401K years, so do it now if possible.
3. Pay off the student loan debt and keep doing the 401K or IRA.
4. With your cash flow, I wouldn’t worry about the emergency fund until the loan is paid off. Your monthly income is large, and once the credit card is paid off, some of the student loan payoff money could be diverted in case of a real emergency. (temporarily)
5. The important thing is not to go into debt for anything else, and not to inflate your lifestyle due to the increased income until you are done with the debt :) For one year of sacrifice, you will get a debt free life….. until you buy the house or car or whatever :) Having made the sacrifice to pay all debt off in 12-15 months, you will be very very careful in the future, I am sure, with debt load. Congrats on thinking ahead and best wishes to you.

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Stephan April 16, 2010 at 10:54 am

your fifth tip is probably the most important one. Dont let the money get to your head, if it does, 72,000 wont seem like enough and shortly thereafter you will be back in debt.

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Brian April 16, 2010 at 10:34 am

Congrats on getting a job rigth out of school. do the steps stated in post and the other comments (credit cards, 401K match, student loans, emergency fund – in that order). Once you achieve the 401K match, twice a year increase your contribution by 1%. Even if your salary stays the same, after a few years you will be contributing close to 10% and never even realize that you did it. The changes in your paycheck are so small that you don’t miss the money after a few months.

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Stephan April 16, 2010 at 10:53 am

First of all, congrats on getting that job, you should consider yourself very lucky especially in these tough economic times. Definitely pay off your credit card debt first. From my experience in the credit card debt field, the sooner you get rid of it the better. Its important you learn to live a debt free life when your young so you dont end up in a situation where you have thousands of dollars of debt, lose your job, and end up looking at debt settlement or bankruptcy. Congrats, and keep doing the right things to avoid the horrible situations a lot of your fellow americans are in.

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WR April 17, 2010 at 10:06 pm

I disagree with much of the above (mostly). Not too long ago, I was 25k in debt and I am now a millionaire. YMMV.

You should work out a percentage that is good for you but you need to build ALL of these simultaneously. I firmly believe that it is not the amounts but the habits that matter most for long term wealth. Here are my suggestions:

1. Do your best work at your job. be a superstar.
2. Start building your 6 month Contingency fund (Maybe 10%). This does not have to replace your income, only help you live and find a new job for 6 months.
3. Pay your Debt (10%). Debt Elimination should be a priority. Debt is self imposed slavery.
4. Invest in your Retirement plan- 401K most likely. Try to meet the match. That is, if your company will match 4%, contribute at least that to get the match. This is free money.
5. Within your investments, stick with Index Mutual funds. 60% Total Market Stock Index and 40% Bond Index (lots of Fed & State). The Stocks are the higher Risk/ Higher Growth potential. The Bonds are the More Stable investments. Also, When the world is awash with good news, sunshine and a stock market that can do no wrong, start to divert more money to your bond funds. When there is nothing but bad news, the world is about to end, etc. etc. buying extended equity index funds from Vanguard/ T. Rowe Price at a bargain will serve you well.
6. Live Frugally. Buy used cars. furnish your house/apt. with Craigslist. bag your own lunches and brew your own coffee. Trust me, it makes a huge difference.
7. Invest the money you save from #6 into Stock Mutual Funds at Vanguard or TRP. No load, Low Expense ratio funds can make you rich.
8. Rebalance to your 60% stock / 40% Bond Asset Allocation twice per year.
9. Give to charity. Work at a soup kitchen, Give money to your local food bank or do whatever you feel is an act of charity. 10% (No Less). Your purpose in life, whether your realize it yet or not, is to help others.

Live off the rest.

The Critical area where I diverge from the rational advice of some other respondents is that I firmly believe that you must do these things simultaneously. Contribution, Investing and Debt elimination are habits that need to practiced every day. The amounts and/or percentages can vary but you must build strong rituals in all these areas. Even if it is 2%, 2%, 2% you will develop the habit and start to see the growth almost immediately. That is very powerful.

I know that you will immediately realize that by NOT paying off CC debt your are losing money. It is OK to slant the percentages toward your higher interest debt but developing your lifelong habit is far more valuable to you than cramming for this one test.

Best of luck to you.

-WR

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Christina April 18, 2010 at 10:22 am

Love your suggestion, especially the last part. When people try to pay of their debt, set aside for their emergency fund, save etc..etc..we tend to forget to share what little we have.

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Bob September 10, 2010 at 1:20 pm

Paying off the credit card debt is obviously number one. Delay the student loan early payoff. Some student loans can be deferred if you are unemployed, financial emergency, etc. Also, if you would change careers and work for a public or non-profit, the government or employer may have a program that pays off some of your student loans. Build a reserve for a car, apartment deposit, vacation, housing downpayment, retirement, etc.

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Griff April 19, 2010 at 9:29 pm

I agree with Marci…just find a reasonable budget, be diligent in sticking to your budget that way when your 2nd year of employment comes around, you will have pleanty of time & extra money to go towards savings not debt. Congrats on the job.

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Joel Gray May 15, 2010 at 8:03 pm

Paying off you credit card debt is a good way to go. However, the discipline to avoid using the card irresponsibly is even more crucial or even after paying off CC, you may find yourself right back where you started.
Good Luck.

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Jay September 12, 2010 at 11:55 pm

There’s some really good advice on this page and not just the article itself. Some comments give excellent advice. I like WR’s advice, but I do think you should try to pay off your CC debt as soon as possible. It will be difficult to pay off the student loans in 1 year unless you really live frugally and with the amount you’re going to be earning as a starting salary, that will be tough. Nonetheless, you will pay off your loans in a very short term because your disposable income will be large and you have enough financial sense to do so (which is evident from the fact that you sought out financial advice… free of charge).

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