Real-life case study: Should I save money or pay off debt?

An issue was raised in the comments of my recent post, Celebrating One Year of Homeownership. In that post, I mentioned that we currently have over $30,000 in liquid savings. At least one reader felt that, with our level of debt (currently over $390,000), that this was an excessive amount and instead we should pay down some of our debt. So I thought that this was a good situation to weigh the eternal savings-or-debt debate again using my own situation as case study.

First, Some Updates and Future Plans

  • The shed: We had the old shed demolished and removed and the new shed assembled, which cost about $500.
  • The back deck: We also got an estimate on the back deck. The issues there are that the paving is cracked throughout and, in certain places, the edge of the pool is crumbling, well, into the pool.
  • The handrail: The quote we received was to resurface the entire back deck, to address the structural issues along the edge, and to install a handrail in the steps into the shallow end of the pool.

That quote came back in the neighborhood of $7,500. This seems like a lot to us, so we are going to get another quote as well as ask some questions about this one. For example, the estimate lumps some things together that I think could be broken out if we wanted to do a less extensive repair.

In other words, we want to know how much it would cost if we focused exclusively on the structural/safety issues and postponed the more cosmetic repairs for sometime down the road. We do need to at least get the crumbling portion fixed and I would feel a lot safer getting in and out of the pool if we had a handrail.

The Argument For Saving

The recommended size of an emergency fund varies, but between three to 12 months is the usual range given (that I have seen, anyway). The amount you choose depends on your monthly commitments, debt level, and tolerance for risk.

I estimate that our monthly expenses (excluding debt payments) total $3,000 per month. Now, some of this includes expenses like cable that could easily be trimmed if needed so the total would be $2,500 per month.

My Student Loan Debt

I currently pay $1,000 per month toward my student loan debt. This is more than twice the minimum (which is currently $400). I direct everything in excess of the minimum toward my smallest balance. (Although my loan is a federal consolidated loan and everything is at one interest rate, I have two sub-balances — an unsubsidized balance and a subsidized balance.)

Jake's Student Loan Debt

Jake is currently paying $1,500 per month toward his student loan debt, also essentially twice his minimum. He has five different balances with different servicers, at a variety of interest rates, and he directs the amounts in excess of the minimum toward the highest interest loan.

Our Savings Options

So our current total expenses are $5,500 per month, though we could cut that significantly if we had to. (In addition to cutting things like cable, we could only pay the minimum on our debts.)

Amusingly to me, now that we have made so much headway on our debt and our income, Jake has become very risk-averse, and would like us to have 12 months' of expenses in an online savings account. This means that he'd feel more comfortable with approximately $50,000 in the bank. While it turns out I have a little more tolerance for risk than he does and feel like that's too much emergency fund, in a marriage these decisions need to be made jointly.

The Argument For Paying Down Debt

The benefits for paying down debt should be fairly obvious, but I'll try to articulate them here. The biggest benefit is that the fewer debts you have, the less money you need to live. Using some of our money to pay off some debt means that, instead of needing $5,500 per month to live, we could get by with less. If we were able to pay off all our debt, I imagine that $1,500 would be more than enough, and anything else would be living high on the hog. Exciting stuff!

Our Debt Options

However, all debt repayments aren't created equal. There's the debt snowball method, which involves paying off your smallest balance first. There's the debt avalanche, which involves paying toward the highest interest rate debt first. The former means that you pay off small debts completely faster, thus freeing up money previously allocated to a monthly payment. The latter means that you pay the least amount in interest over the life of your loans.

My student loans and my mortgage are at nearly identical rates (4.5% on one, 4.6% on the other) so the debt avalanche doesn't really apply to my situation. This is fine with me because the debt snowball appeals more to my psyche anyway — important when it comes to staying motivated and paying off such large balances. I like the idea of creating additional flexibility in my monthly budget.

Creating Flexibility Requires a Down Payment

My student loans are on a graduated plan, which means the monthly payment increases every two years or after two years' worth of repayments, whichever comes first. This means that with every extra payment I make, I am actually buying myself less flexibility because my payment increase will happen sooner. This continues unless I pay off one of the sub-balances completely.

While I have a traditional mortgage and not a graduated or balloon-payment mortgage, my mortgage is similar to my student loans. How? In that making an extra payment may reduce my total debt but doesn't reduce my monthly commitments or create any flexibility in my monthly budget. Unlike student loans, however, where refinancing isn't possible, I can refinance my mortgage.

The Goal — Eliminate PMI to Create Flexibility

So that's the current plan. While we are paying more than the minimum on both our student loans and on our mortgage, we're diverting a significant percentage of our income to save for a down payment fast so that we can refinance the mortgage, hopefully before the end of the year. The goal is to pay down enough of the mortgage to get rid of PMI and still have enough savings left over to have a three-month emergency fund after the refinance. This is another reason we decided to put off a total resurfacing of our deck — the cost of that repair/upgrade is too significant a percentage of the total we need to refinance.

Have you been in a situation where you had to choose between several, equally valid financial paths? What did you do? Share your story in the comments below!

(Editor's note: Honey Smith's situation lends itself to all sorts of interesting discussions. If you can lay out a different direction for Honey and Jake to pursue in your comments, we may use it as the basis for further articles on the subject of debt versus saving. You can also reach out to me via email at [email protected] to offer your suggestions.)

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JoeM
JoeM
5 years ago

I’ve been aggressively repaying my student loans early with large lump payments every few months. This past month I had the choice of eliminating my second to last loan or paying off my car.

While my car interest rate was a bit lower than my student loans, I still paid it off. It removed the second largest monthly bill for me. I’ll use that freed cash to add onto my student loan payment, while also continuing my occasional lump sum payments.

JB
JB
4 years ago
Reply to  JoeM

My wife and I did something similar. We realized we owed $8k on her car and $8k on a college loan. The car was at 1.9% and the college loan at 5%, but the minimum loan payment was $89 and the car payment was $359. Now we have a “free” car and I send $450 a month to the loan. The other way around would have saved interest, but now if I ever have financial issues I can fall back to the $89 payment instead of being stuck paying $359.

Marcia
Marcia
5 years ago

You have a plan – stick to it.
You are a team – work together!
You have savings – build on them.
You have debts – keep paying more than the minimum. I did this as well, and while brief times of low debt have come my way, I have been diligent to do those three things as well. Sticking to the plan means that when you are finally debt free you will be able to amp up the savings for short and long term adventures. Well done.

Jen from Boston
Jen from Boston
5 years ago

I like your idea of getting rid of the PMI and refinancing the mortgage, but still having enough for an emergency fund. I’d focus on that, and in your shoes any work on the house would be to fix or prevent structural issues. You have plenty of time for the cosmetic stuff. Once the PMI is gone I’d revisit your financial goals. I do think you should have a good chunk of cash on hand for emergencies. For starters, you’ve got a mortgage so if one you loses your job you still need to pay the mortgage. So having an… Read more »

Sylvia @Professional Girl
Sylvia @Professional Girl
5 years ago

I have thought about splitting my funds equally to saving and debt but ultimately chose the path of aggressively repaying my debt. Also I am a fan of snowballing my debt. I have just under 50% paid off using this method.

Chadnudj
Chadnudj
5 years ago

“Unlike student loans, however, where refinancing isn’t possible, I can refinance my mortgage.”

Um, you can refinance your student loans. Check with SoFi (and others) out there — you can refinance student loans, although admittedly not with the ease/frequency necessarily of a mortgage.

Honey Smith
Honey Smith
5 years ago
Reply to  Chadnudj

I think the odds of getting an interest rate below 4.5% with loan benefits comparable to the federal loan benefits I have are pretty slim, though these consolidation companies might be a good deal for those with private loans at high interest rates.

Erin
Erin
5 years ago
Reply to  Chadnudj

The thing is, it depends on the loans. Not all can be refinanced, and it’s not always effective to do so. Refinancing doesn’t automatically equal a payment/interest drop, after all. My loans sit at 3.5% and 1.65% respectively–that’s as good as I’m going to do.

Chadnudj
Chadnudj
5 years ago

And really, is the PMI all THAT bad? I mean, how much in PMI are you paying each month, versus how much in total student loan interest each month?

I mean, I’m buying a house and will have PMI (yeah, I know, don’t buy unless you have 20%, but we live in a high cost of living area and buying is MUCH cheaper than renting), but I’m not sweating it, since the PMI payments are relatively small compared to my monthly student loan interest payments…..am I wrong in that analysis?

Honey Smith
Honey Smith
5 years ago
Reply to  Chadnudj

I think our PMI is about $250, plus the principal reduction of a refinance would probably lower our monthly payment by another $250 (total ballpark on my part).

My student loan interest is about $250. If you add in Jake’s interest, the total’s probably $500 per month. So the math is pretty similar however you slice it.

JB
JB
4 years ago
Reply to  Honey Smith

I had a creative and downright lucky way of getting rid of PMI in our second year living in our house. Our electric rates on Long Island are insane, so I always wanted to install solar. After extensive research, my wife and I decided to buy rather than lease. We financed the system, but the payments are much less than our electric bill used to be. Around the time the system was being installed, our neighbor sold his house for considerably more than we paid, so I got the bright idea to have the bank send out an appraiser after… Read more »

Penny Price
Penny Price
5 years ago
Reply to  Chadnudj

Yes; PMI is all that “bad”. In fact, the way new first-time homebuyer mortgages through the Feds have included a permanent sort of PMI is rather sneaky, too. I think you should write an article about PMI and other “extra” mortgage costs/fees. Describe what they are, how they add up, what they generally cost, etc. PMI is so yucky!

Bryan
Bryan
5 years ago

I just went through a similar decision process regarding what debts we should pay off now. We had recently sold a former home/rental property that enabled us to eliminate 85% of all our real estate debt.

We ended up making the emotional decision of paying off our personal residence. It is a great feeling to live in a paid for home.

Fast forward many years and you will be in the same situation based on your plans. Keep up the great work!

Sanjeev Shrestha
Sanjeev Shrestha
5 years ago

Nice Article… The best the method I would suggest is Dave Ramsey’s Baby Steps. You can modify little bit to meet your needs but that should be the blue print.

In my opinion, his baby steps are more practical and simple than other financial pundits to get out of debt and save.

Yeah, it’s little tough decision but it also means you are heading towards right direction.

Sue
Sue
5 years ago

I’m curious about your choice to refinance your mortgage. If you are saving to payoff enough of your mortgage to get rid of the PMI, it is MUCH easier and cheaper to request the PMI be dropped once it falls below 80% LTV. It depends on your mortgage company of course, but look into it. You’re going to need an appraisal either way so hopefully your real estate market is on the upswing. The 3’s% interest rates are tempting, but not if you have to pay closing costs all over again. (I just looked into this for myself, so I… Read more »

Jessica
Jessica
5 years ago
Reply to  Sue

FHA loans don’t allow the elimination of mortgage insurance for a long time (11 years, maybe?) on 30 year loans and not at all on 15 year loans (this is what I have), no matter how much equity you have. Many lenders have moved this direction so that’s why a full refi is necessary to remove this for some borrowers.

HKR
HKR
5 years ago
Reply to  Jessica

It’s not lenders who have moved this direction, it’s borrowers. To get a conventional loan, you need at least 5% down, plus closing costs. Many borrowers don’t want to take the time to save that much, and FHA allows you to get a loan with 3.5% down (for which service they charge a significant fee that they graciously allow you to roll into the loan). For loans originated after 2013, you can only cancel PMI after 11 years if you had at least 10% down to start. Loans originated prior to 2013 could be cancelled when they reach 78% LTV… Read more »

Even Steven
Even Steven
5 years ago

One thing that I have learned about my debt and the best way to attack it is complete and total focus and dedication. I saw that you are paying off this student loan and that student loan and mortgage, etc and I think each person has their own path, but ours was to make each item a priority one at at time. If it’s the mortgage and PMI, go as hard as possible and focus.

Best of luck Honey!

Lilli
Lilli
5 years ago
Reply to  Even Steven

I second this approach! We finished paying off my husband’s student loan about 2 months ago and now we’re focusing on the car. There is something satisfying about checking one debt off the list that I like to tackle them one at a time according to interest rate. The only debt we haven’t tackled according to the interest rate is actually the mortgage – that’s a big number to tackle compared to our other debts and we’d never get it paid off before the other debts were paid in full on their normal timetable. We’d rather get everything BUT the… Read more »

Erin
Erin
5 years ago
Reply to  Even Steven

That’s been my approach as well. I’d even go so far as to wonder, if her husband’s loans are higher interest then why make extra payments towards hers at all, or visa-versa? Instead of dividing it by his-and-hers, assess all debts in total and pay off the one that’s bugging you the most first, then move on to the next.

Paul
Paul
5 years ago

I recently completed a contract and received a bonus of about $5800 at the end of the contract. The contract ending also means that I am currently unemployed. We have a little over $5000 in our emergency fund (3 months of expenses). I also owed a little over $5900 for repairs on a house I recently sold. One of our options were to save the bonus and make minimum payments on the credit card for the house repairs. Another option was to pay off the credit card and use the emergency fund as necessary until I find employment. My wife… Read more »

Alea
Alea
5 years ago

Honey, I’ve loved following your story and your progress. I am with your husband on this issue, as homeowners you should have that 12 month emergency fund in place. First, it will give your husband peace of mind, there is nothing more stressful than always worrying that there is not enough money. Second, as a homeowner, I always feel that you have a bigger chain and ball to your legs than a renter. As a renter, you can always move to a cheaper place, or with family, but with a home, you don’t want the nightmare of having to fall… Read more »

Mike in NH
Mike in NH
5 years ago
Reply to  Alea

I agree. If one of the main purposes of money is security, then it doesn’t make much sense to save an amount that is insufficient to help you feel secure.

Sam
Sam
5 years ago

It is an age old dilemma. When we were killing our unsecured debt, our emergency fund was much smaller although we had way more debt ($735,000 in debt vs. $510,000 now). We worked a modified Dave Ramsey debt snowball. While we did smallest to largest debt and were super focused, basically sacrificing a year of focusing just on debt, we still continued to fund retirement when we were killing debt. At present, we have about $40,000 in emergency fund and earmarked savings (i.e. savings for taxes and insurance, etc.). And after many years of being debt free (except for our… Read more »

Jessica
Jessica
5 years ago

I have a healthy income but spent several years from 2011 to 2013 paying off north of $100k in non-educational unsecured debt (I know, I know) and living without any significant savings. I was on a “payoff” roll so in 2014 I decided to work on my $80k student loan balance and last year I was able to wipe the last of it out with an end of the year bonus. When I made the final payment I had almost nothing in emergency savings but I did it anyway because I wanted to be done with the debt. I made… Read more »

Sudarto
Sudarto
5 years ago

I prefer to pay off large debts with high interest. This will reduce the expenditure of funds for interest payments. In addition, by accelerating repayment, our credit score will not be hurt.
Meanwhile, the small loan is easier to handle. In addition, it will not require huge funds for the payment of interest.

superbien
superbien
5 years ago

Honey, I love the progress you’ve made! Many kudos. I read your updates and think warm fuzzies but rarely remember to comment. You’re on a wonderful path!

I’m with you on the emotional approach of the debt snowball. Going from small amount to large gives you a punch of delight that motivates all the cost cutting. People with more engineering bents just don’t understand that, I think. For them it’s all logic all the time, and a decision made is a decision carried out. The rest of us need motivation between making and carrying out those decisions!

Janneth
Janneth
5 years ago

Wow this is really a big help. I learn a lot from you post. I am also into saving but I also believe that we should invest in a right basket.

Your blog is very informative. Thanks!

Linda Vergon
5 years ago

(This comment came from Mario, a reader of our daily newsletter.) Hi, I read the post this morning on feedly on my phone and I wanted to add a comment. I understand that being debt free provides a good feeling as you can imagine how it would be to shrink your nut and live high on the hog. However there are a few things to consider 1. As she says, all debt is not created equal, for example, the mortgage is not the same kind of debt as a student loan. Mortgage interest is currently tax deductible and you end… Read more »

Marie
Marie
5 years ago

We were very aggressive with mortgage pre-payments in order to eliminate PMI, and also decided to eliminate escrow at the same time. I had heard that it could be difficult to get rid of PMI, so I had expected a battle. It was surprisingly easy. What I didn’t expect was how hard it was to eliminate escrow. The mortgage company kept insisting it was in my best interest for them to collect my taxes and pay them for me. Yeah, right. They were paying it at the last minute in November, whereas I pay it when the bill comes in… Read more »

Sam
Sam
5 years ago
Reply to  Marie

I’m anti escrow myself and what I’ve found over multiple real estate transactions (purchases and refinancing) is that mortgage companies/banks now treat escrowing as norm and required. Why, because they make tons and tons and tons of money off all that money they collect and hold for you. In most states any interest earned by the mortgage servicer goes to the servicer, not the customer (there are a few states where that is not legal). So, they have this huge cash cow and therefore make it as difficult as possible to avoid it. I’ve found that the easiest way to… Read more »

Glenn
Glenn
5 years ago

The question I love to think about is “How much retirement do you need if you don’t have any bills?” The dilemma I have is I’m currently renting my condo to my parents at cost. I’m also in property management and I know what tenants can do to a home. I believe they are the best tenants I can have. I can pay off the condo and have a somewhat small emergency fund(super low returns) Or I can pay cash for another condo(still have a small emergency fund) and let the rent payments from that condo pay off the debt.… Read more »

Erin
Erin
5 years ago

Another consideration that I haven’t seen mentioned is the return on your money. For example, I have student loan debt at 3.5% and 1.65% interest, and a car loan at 2.25%. The flip-side of that is a high interest savings account that generates 0.75% and my retirement account is up 2% this year (though jeez, maybe not for long). I look at that and see that my best return on investment at this moment is to pay off my highest interest student loan and car loan; when those are done (or when I can save at a better rate, whichever… Read more »

Harry King
Harry King
5 years ago

This is a great subject! We really need to learn to settle off our debts to avoid bigger problems in the future. This also reminds us to be responsible with spending money. This is a key towards zero-ing debts and start your way to financial freedom.

Meghan Cross
Meghan Cross
4 years ago

Thank you for the article and for sharing your story for contemplation and visual’s sake. It helps us consider our own situations because of connecting with yours. I believe in moderation, especially when it comes to the psychology of our situations. Having a little extra in savings despite the debt can be a greater peace of mind that one extra year, for example, of paying it back. However, if there is a tendency to spending anything in savings, then for some it may be best to put it all towards payback. I think it depends on the person, the personality… Read more »

Tammy
Tammy
4 years ago

I found your post to offer some perspective. I’m hopeful I can ask for advise here too! I’m pretty torn on how to go about either saving or paying off my student loan debt. I had this crazy thought that next year, I could literally live off of my savings. I have $25k saved at the age of 28, and I make a little over $55k per year. After taxes, I bring home $43,200 per month. If I lived off the $25k I have saved, I could use all of my income to pay off my remaining student loans —… Read more »

Ansley
Ansley
3 years ago

My husband and I have a combined $47k in student loan debt. He and I are both savers and we’re divided our unused income into savings and loan payments. Then I thought of something that changed my perspective: if the interest rate of my savings is LESS than the interest in my debt, then I am losing money over time. If I aggressively pay of my debt, then when it is paid off, I can divert all that money to savings. Our student loan interest rates are 4.25%, which isn’t too high, but is significantly higher than any interest rate… Read more »

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