Student Loan Strategies: Maximizing Net Worth

Posted On August 11, 2014 By Admin In Financial Planning /  

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For today’s young professionals, student loans have grown to become a significant financial obstacle. A common question is if it makes sense to pay off these loans early.

First, before considering making additional payments, I’d counsel investors to:
1) have paid off any credit card balances;
2) establish an emergency fund of at least 6 months reserves, and 12 months if their income is unknown or employment is in any way tentative; and
3) save up for a house down payment, if home ownership is a goal.

Having the cash available to pay off a loan is terrific, but I caution people to not forgo their retirement savings in lieu of their student loans.  I know that for many recent graduates it seems appealing to get out from under those loans as quickly as possible, so they think they should wait on contributing to their 401(k) and put as much as possible towards the loans.  When you look at the effects of compounding, however, the money you invest in your 20’s and 30’s into your retirement accounts is much more valuable than the same dollars invested in your 40’s and 50’s.  Often times your net worth will be higher by starting to invest earlier and taking your time with the loan repayment.  And of course, you can test this projection with most financial planning software programs or a spreadsheet.

Another factor to consider on the decision to repay is the tax deduction.  For 2014, you can deduct up to $2,500 in student loan interest from your federal tax return.  This deduction is limited, however, based on your modified adjusted gross income (MAGI).

Single taxpayer: full deduction below $65,000 MAGI, phaseout $65,000 – $80,000
Married filing jointly: full deduction below $130,000 MAGI, phaseout $130,000 – $160,000

I would note that student loan rates are variable and have crept up in the past couple of years. Additionally, as your career progresses and income increases, many families lose their eligibility to take advantage of this tax deduction. I point this out because another important question is: Which is better to pre-pay, student loans or your home mortgage?  The mortgage interest deduction does not have an income limit and is not capped at $2,500.  Also, most mortgages are fixed, not variable.  That’s why I suggest most borrowers make extra payments towards student loans rather than their home mortgage.

For those who can receive the student loan interest tax deduction, it lowers your cost of borrowing, so I would consider the after-tax cost of borrowing when deciding if early loan repayment makes sense.  Most borrowers I counsel have multiple loans at various interest rates, so it is often best to send extra payments towards the student loan with the highest interest rate and make only the minimum payments on the other loans.  Over time, we will pay off the highest rate loan first.  Then that monthly payment can be applied towards other loans.  Additionally, paying off one loan first will reduce your total monthly minimum payments, which is highly valuable should you have any sort of temporary setback like a job loss.

The earlier you can make extra payments, the better.  If your interest rate is 5%, paying an extra $1,000 today will mean that you are saving $50 in interest in every year going forward.  Early principal payments will shorten the length of the loan more dramatically than extra payments made in future years.  If you scrimp a bit now and make extra payments, you will reduce your total interest payments over the life of the loan.

Be careful about consolidating loans. Most people consolidate to lower their monthly payment amount, but inadvertently add years to their loans and thousands in interest payments. Additionally, if you are consolidating Federal loans, such as Stafford Loans, into private loans, you will be giving up access to Federal loans benefits such as forbearance, income-based payments, or loan forgiveness. Before consolidating, make sure you are not going to lose any pre-paid interest if you are ahead on your payment schedule.

Many people think a financial plan deals only with the Asset side of your balance sheet, but some of the most important choices are about how to manage your Liabilities. Student loans are an investment in yourself, so make sure your subsequent cash flow decisions are helping to maximize your net worth in the long run.

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A Young Family’s Guide to Life Insurance

Posted On July 21, 2014 By Admin In Financial Planning /  

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Life insurance isn’t for you – you really purchase life insurance to protect someone else.  If you have a spouse, children, parents, or even a business that is depending on your future work and income then you should consider if a life insurance policy makes sense for you.  Life insurance is an essential piece in the financial planning process that is often overlooked by many young families.  It is not always easy to discuss the reality of our own mortality, but most people feel more secure once they have a life insurance policy in place.  

Life Insurance premiums are based on your age and health, so the best time to get a policy is when you are young and healthy; you will be able to get the best price from an insurer and lock in your cost and coverage.  If you later develop health issues, such as diabetes, high blood pressure, or a more serious condition, you may find that you are now uninsurable or that adequate coverage is prohibitively expensive. 

A young professional is probably not thinking about life insurance, but with decades of earnings ahead of them, actually has the greatest amount of future income that would require replacing in the event of their unexpectedly passing.  An older individual, say with grown children, does not have the same liabilities or as many years of future income that would require replacing for their family.  

As a Financial Planner, my recommendation is to use Term Life insurance for young families.  Many individuals can buy a policy for under $1000 a year and that may be the last policy they will ever need to own.  With Term Life, you lock in a low cost that is guaranteed to not increase over the life of the policy.  We look at 15, 20, and 30 year policies and try to match the duration of your future needs, as well as to make sure that the policy will be in force through your children’s college years.  To decide on a benefit amount, we look at a number of factors including your income, liabilities, and children’s needs.  However, as a rule of thumb, a benefit of 8-12 times your annual income is often adequate.  Rather than thinking about life insurance in terms of mortality, it helps to frame the conversation around looking at your family’s potential need for income replacement.

You may hear about other types of life insurance, but insurance is not the most efficient tool for investing, so I typically steer clients away from policies that have a cash value or are used as an investment vehicle.  “Buy Term and Invest the Difference” is my approach and the philosophy embraced by many financial professionals.  In planning for clients for a period of decades, our goal is for them to become self-insured by their 50’s, so that they have enough in assets that life insurance is not a necessity.  When their Term Life insurance policy reaches the end of its term period, they may not need to purchase another policy.   

There are some reasons to buy a permanent policy, such as Universal Life or Whole Life, if you have a specific requirement to leave money at your passing.  This might be for charitable purposes, for business requirements, to fund a special needs trust, or to pay for estate taxes.  Outside of very specific needs like these, most individuals will be well served with a term policy instead.

Two other thoughts on buying life insurance:

1) Don’t rely on a group life policy with your employer.  Employer life insurance benefits are generally not portable if you change jobs, do not have fixed premiums, and may be dropped if your company amends their benefit programs.  You’re not in control with a group policy.  If you are in relatively good health, buying an individual policy is typically a better solution.  However, if you have some health concerns, a group policy may be affordable and the only coverage you can obtain.

2) Term Life is largely a “commodity” product today, so it pays to shop around or use an independent agent, such as myself, who can get quotes from multiple companies. Each year, when I send in my check for $350 for my annual premium, I think how glad I am to have my term policy in place. Term insurance can be incredibly cheap for a significant amount of coverage.

I hope that none of my clients will ever need to make a claim on their Term Life policies, but I have to say that it has been very satisfying to know that I have protected quite a few families over the past 10 years with this vital program. It may not be the most interesting or significant part of a financial plan, but if a claim did occur, it would be the only part of the plan that mattered. If life insurance is something that you haven’t gotten around to, please give me a call, and we will get it done for you. And your spouse will sleep easier, rather than wondering, What if?

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