Mailbag: What’s the Best way to Allocate your Income if You’re in Debt?

by RJ

in Money Management

I give subscribers to the Gen Y Wealth Newsletter a chance to ask me a question or two about personal finance. The purpose of this for me is to find specifically what’s on people’s mind financially.

A few weeks ago, I received a question from a female reader, let’s call her Arwen (Liv Tyler’s character in Lord of the Rings which I watched last night) in a situation that’s very common among members of Gen Y. Knowing that I have gotten a few questions like this in the past, I thought I could expand on my answer in a post.

Here is Arwen’s email:

  • I have about 30K in student loans to repay – how can I pay them back while still saving for other goals?
  • I just got hired making about $30K a year and I’m eligible for benefits and 401(K) in 90 days…how do I choose what’s right for me?
  • I’d really like to travel, but my savings is currently devoted to staying just that: savings. My savings account is my emergency fund and I’ve built up about $1K to act as a cushion. How can I still save up for a trip while paying for loans, rent, utilities, incidentals, groceries, retirement, etc.?

Basically, I’m looking for a post on financial balance. How can a typical college grad best allocate my income? Should I devote more of my money to paying off the loans early or should I look toward retirement? Should I look into loan consolidation? Where do I even begin when those 90 days is up and I have to choose a 401(K) plan?


Find the Balance with Focus

The biggest dilemma facing Arwen right now is how to allocate her income. Should she pay the minimum on her student loans and invest for retirement? Should she pay off the student loans and wait to invest for retirement? Or, should she pay the minimum on student loans, invest some, and use the rest to save for some short-term goals? Plus, which one of these options provides for the best “financial balance.”

While my answer is probably not what Arwen wants to hear it’s what I believe the best solution is for her. That is, that right now, being 30K in debt, it’s not time to think about financial balance. Instead, Arwen needs to think about financial focus.

30K is a lot of money to be in debt. The magic of compound interest is either works against you or for you. In Arwen’s case, it’s working against her.

Here’s how I would allocate my income if I were in Arwen’s situation.

If my student debt had a higher interest rate than 6%, I would pay that off in full before investing for retirement. Even if my employer matched my 401(k) contributions.

If my student debt was below 6% and my employer matched my 401(k) contributions, I would contribute to get the maximum match and then work to pay off my student loans in full with the remaining income.

If my employer doesn’t offer a 401(k) match and my student loans were below 6%, then I would focus on just one thing. I would either invest as much as I can in a Roth IRA, if early retirement was my goal, because its withdrawals rules are more flexible then a 401(k), or use all of my income to pay off my student loans. Personally, I would avoid doing both because very little will actually be accomplished.

What to Do With Benefits

As far as benefits in Arwen’s situations, I wouldn’t go without health insurance. It’s expensive but just one broken bone or sickness can rack up more than 10K in debt fast.

If she isn’t already, Arwen should get on a health insurance plan for the next 90 days. If she is under 26 (even higher in some states), she can join her parents plan as a dependent. Another option is extending the student insurance she had in college. If all those fail, Arwen should get on a high deductible health plan for the next three months. A policy like this can be had for around $100 a month and is well worth the protection.

In 90 days, when the time comes to select a health insurance plan, Arwen should evaluate all of the company’s options and her own health history. Assuming she maintains a healthy lifestyle and only goes to the doctor once or twice a year for wellness checkups, the cheapest health insurance plan might save her the most money. If Arwen is on a few prescriptions and has gone to the doctor frequently in the past, maybe the more expensive plan will cost her the least in the long run.

What about Other Goals?

Like many other young adults,  Arwen’s wants to travel. Unfortunately for Arwen, right now there isn’t a lot of money left to save for other goals.

That doesn’t necessarily mean that money she can’t earn more, in the near future. As Benjamin Franklin once said, “”There are two ways to increase your wealth. Increase your means or decrease your wants. The best way is to do both at the same time.

To increase Arwen’s means, she should look to see how she at ways to make more money. Depending on what Arwen’s skills are, she should look for extra opportunity to earn income.

Last, I would tell Arwen that the lack of money doesn’t mean she can’t travel. Maybe, instead of traveling abroad to Europe, the best option for now might be taking a camping trip. What about taking a road trip and sleeping on friend’s couches? There are always options, if you think creatively.

Your Turn

What advice do you have to offer to Arwen? What would you do if you were in her situation?


Photo by: Jenifercw

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{ 12 comments… read them below or add one }

RachelNo Gravatar January 24, 2011 at 9:27 am

My husband and I used loan calculators to find our “loan payment sweet spot.” We knew we wanted to save for a variety of goals while paying down his student loan debt and our car loan. We examined the largest loan first–the student loan. We used a loan repayment calculator to determine how long it would take us to pay off the loan at our current payment amount. Then we examined how much sooner $100 would pay off the debt. How much longer with $100 less. We played with a variety of amounts until we found a “sweet spot” where additional payments wouldn’t affect the length of the loan substantially and less would leave us paying on the loan longer than we’d like. We did this for both of our loans. Then we examined our savings. Every time we receive a raise, we increase our contribution to our employer’s retirement plan (403b/401ks). We are both well above the employer contribution mark. The remaining chunk of money goes into savings. We allocate various amounts to different buckets.


TimNo Gravatar January 24, 2011 at 10:00 am

As far as travel, the “Explore” feature on Kayak lets you input a dollar range and season, and shows where you can fly for various approximate amounts.
If Arwen sets up a dedicated savings account with just a small amount per paycheck (say $25-30), she can finance a cool trip relatively quickly. Now about getting time off from a new job… ;-)


EricNo Gravatar January 24, 2011 at 10:47 am

This is quite scary, as after I finish graduate school, I may end up with double or triple Arwen’s debt. Though I don’t feel it yet, I know I’m digging myself into a financial ditch; it is just the most practical option for my career path. My fear is never being able to live comfortably because of this debt. So I anticipate doing a lot of thinking about the allocation of my money in the future. Most, if not all, of it will probably be going towards loans.


Sad Bears FanNo Gravatar January 24, 2011 at 11:02 am

I am probably the last person who should give financial advice, unless mortgage related, but I love your blog RJ and after the last fictitious post using my name, I felt compelled to share. Although I am not the most frugal, I have certainly been there. I still have a student loan at about $17,000 and about a year and some change ago, I paid off $12,000 in credit card debt. So I have positive experience.

As a young person, making money for the first time, making your own decisions, it is natural to make very selfish decisions.However, in the end, the easiest way isn’t the most fun. So often we feel like we are owed certain things that we don’t need and in the end, the smartest choice is to not proceed to buy those things. In my situation, two/rather three things helped me:

1. My fiance is a frugal (I know that is not an option for most)
2. I found a financial goal that was very important to me to save for (I find its easier for this to be tangible – saving for a home, saving for an investment, not just to have money in the bank)
3. I found pleasure in not buying things (at first walking into best buy and not buying something felt weird, now its common place).


Pat S.No Gravatar January 24, 2011 at 11:03 am

Arwen is asking the right questions. I agree that the first step absolutely depends on her student loan interest rates, whether they are subsidized or unsubsidized, private or government, and whether they are consolidated.

If Arwen is able to consolidate her student loans at a low interest rate (below 4%), I’d recommend that, while paying the minimum as she further builds her emergency fund and begins to contribute to her 401K.

After building a 3 month emergency fund, she should maintain the employer match to her 401K, while beginning to divert all expendable income into debt repayment.

Just my opinion.



MeganNo Gravatar January 24, 2011 at 1:14 pm

I like this post especially because “Arwen’s” issues are the same issues I’m currently facing. My husband and I have over $40K in student debt (all at less than 6%, thank goodness), $4K in credit card debt, and $18K in auto loans ($16K at 8.5% and $2K at 4.3%).

And of course, with both our 30th birthdays less than three years away I’m worried that we’ve missed the boat on having compound interest really working for us toward our retirement savings.

But, as over-whelming as our situation can feel, we have a plan. We should be consumer debt free in three years, at which point I’ll max out my Roth IRA contributions, my husband will max out his 401(k) contributions (he’s already putting in enough to get the employer match), and we’ll start really working on our student loans.

It probably means putting off buying a house for a good long while — not only do we have very little saved toward a down-payment, but I also can’t justify taking out a mortgage when we have so much in student debt.

I guess that would be my question for you RJ, as one Finance Geek to another, if I had 20% down-payment saved up, had no debt other than student loans, but still had $30-$40K in student loan debt, should I put off buying the house until the debt way paid off?

On the one hand, there are arguments for a house a valuable asset (vs. renting). On the other hand, a mortgage is more debt, even if it is potentially low-interest debt.


RJNo Gravatar January 24, 2011 at 1:59 pm

@Sad Bears Fans – Thanks for the compliments. A couple of thoughts on your comments. Getting married to someone who is even more frugal than I am, has helped tremendously. I don’t mind, that I now have someone reviewing every financial decision I make. Meaningful goals are also very helpful. And since I’m guessing your goal was either an engagement ring or wedding, there’s nothing more worth saving for.

@Pat S. – You bring up a great point, in which I’ll have to cover in another post. Should you continue to build your emergency fund, even when your in debt.

@Megan – Great luck in your goal to become debt free in three years. As for your question, if I was in your situation, I wouldn’t take out an additional debt until my student loans were paid off. Even though a house is a valuable asset, it’s still a debt. More importantly, it opens you up to a lot more risk, your exposures for large expenses increase, and a home decreases your flexibility, which might come in handy if you would ever like to move.


JoeTaxpayerNo Gravatar January 24, 2011 at 5:44 pm

I can make a case for doing a matched 401(k) regardless of the debt’s interest rate. If a company is matching dollar for dollar, usually to 5 or 6% of one’s income, that’s $1500 (or $1800) in the match. In the 15% bracket I’d use Roth 401(k) for the deposit, the match of course would be pre tax.
Even assuming a low rate of return within the 401(k) say 4%, it would take a very long time for the accruing interest to exceed the balance in the retirement side. Far longer than that debt’s term.


PatrickNo Gravatar January 24, 2011 at 8:10 pm

Anyone who has read my replies before knows how important and valuable I view the military and options it provides for young and willing Americans.

Depending upon Arwen’s career field maybe joining the National Guard or Reserves is a viable option which would automatically pay off her student loans. There are many benefits to joining the military after school beside paying off your debt, such as getting work experience and if you are lucky an all paid trip to Europe to do all the backpacking you want.

If the military isn’t for you, then I would recommend you download a debt-reduction-calculation spreadsheet and get an exact payment structure of how long it will take you to pay off your debt. You can read up on snowball effects to paying off debt and what would happen if you increased your payment by $25 a month.


20 and EngagedNo Gravatar January 24, 2011 at 11:15 pm

I would try to pay off debt systematically, not necessarily aggressively, and save to travel. She’s young, and there’s no time like the present. Any additional income she could make would help her in the situation.


MeganNo Gravatar January 25, 2011 at 1:47 pm

Thanks for the advice, RJ. I can help other people solve their problems just fine, but when it comes to my own… I’m just too close, I suspect. :D

And heck, in six months I might be making more like $36,000 a year (instead of $23,000) and our debt-pay off plan might take a lot less time. One can always hope.


LauraNo Gravatar January 31, 2011 at 11:28 pm

I would apply everything I could to the student loans but get a second job making enough to max out a Roth IRA. If you make more than five K, apply it to the student loans.


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