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Author: CPAScott Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 308369  
Subject: Student loan or Car loan: A Decision Date: 7/25/2003 3:48 PM
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(see http://boards.fool.com/Message.asp?mid=19352968)

I've decided to eliminate both debts -- the one Sallie Mae loan now, and the car loan by the end of the year.

Of course, my severance won't cover that, so I have to dig into my e-fund to come up with the rest. But that's ok, because as part of this exercise I looked at how much I wanted in my e-fund and determined it to be overly conservative.

I based my optimal e-fund balance on my total fixed and discretionary expenses including the minimum payments on my student loans. This comes out to $2600/month (see my Cash Flow post at http://boards.fool.com/Message.asp?mid=19328564). For simplicity, I rounded that down to $2500 and thus calculated that my e-fund balance should be $15,000 (2,500 x 6).

But, as I said, that's overly conservative and thus my e-fund (which, prior to receiving my severance was at $14,000) is over-funded. Here's the logic.

Although it would be nice not to have to defer my student loans in the event of a financial crisis, the fact is at 1.8% keeping that money in the e-fund is a poor insurance policy. The risk of such crisis doesn't warrant it, and because the loans can be deferred, it's better to rely on such allowances if necessary. So, out come the student loans.

As I have also made the decision to eliminate my car loan over the next 5 months, I do not need to consider that in my e-fund either. There will be some risk until the loan is fully paid, but it's one I can accept. Thus, out comes that loan as well.

That leaves only two things -- my living expenses and my "discretionary" expenses. No loan obligations are included. From my Cash Flow budget, that works out to be $1,680. Rounding that down slightly to $1,675, the new calculation of my e-fund balance is just over $10,000 (1,675 x 6).

That means that I have everything from my severence PLUS another 4,000 to pay down debt.

For discussion purposes, let's add my severance to my e-fund and come up with a total.

Unfortunately, my severance is about $1,000 less than I anticipated due to the manner in which taxes were withheld on the lump sum portion. Because I started a new job without a lapse in employment, my regular salary at both companies plus the severance will propel me into the next tax bracket for this year, and thus I am currently estimating my tax liablity to see if I should adjust my current withholdings downward to reclaim some of that $1,000 this year.

For this discussion, however, let's leave that alone. Total severence received was about $10,500. Thus, total e-fund = $24,500 (14,000 + 10,500).

OK, the strategy:

Just today I sent Sallie Mae a check for $5,300 as a principal pay-down on one of the two high-rate loans I have there. E-fund balance remaining = $19,200 (24,500 - 5,300).

In order to pay off my car loan by December 2003, I need to make a payment of $6,200 in August. E-fund balance remaining = $13,000 (18,300 - 6,200).

But I must not forget the remaining balance in that Sallie Mae loan, which, after the $5,300 payment will be about $4,700. That payment will be made next week. E-fund balance remaining = $8,300.

Collectively, these three payments will cut my e-fund below it's new threshold by $1,700, and my intention is to pay that back begining in September by applying the former payment to Sallie Mae (about $100) for four months and then, when the auto loan is fully paid off, that balance as well (about $400) for another three months. I do have a car insurance payment that will happen in this timeframe (about $1000), but I don't want to murk up my calculations by including it here right now.

Running an Excel spreadsheet with all this data produced some amazing numbers. I'd like to share them with you. My analysis timeframe is one year (August 2003 - July 2004).

First, some quick facts:
As of August 1, 2003, I have $14,000 and owe $60,050.
Interest on the e-fund is 1.8% (variable)
Interest on the loans are:

* Car - 5.480% fixed
* SLMA 03 - 3.500% variable
* SLMA 07 - 6.875% fixed
* SLMA 08 - 6.875% fixed (this is the loan I'll eliminate)
* Perkins #1 - 5.000% fixed
* Perkins #2 - 5.000% fixed

Base scenario: Keep e-fund & severence.

Net savings (debt):
Principal owed at 7/31/2004 ($ 52,617.82)
Savings at 7/31/2004 24,918.92
Net savings (debt) ($ 27,698.90)
.
Principal reduction:
At 8/1/2003 $ 60,043.29
At 7/31/2004 52,617.82
Reduction $ 7,425.47
.
Savings effect:
At 7/31/2004 $ 24,918.92
At 8/1/2003 13,990.52
Increase (decrease) $ 10,928.40
.

Interest earned (paid):
Interest paid on loans ($ 3,638.05)
Interest earned on savings 428.40
Net interest earned (paid) ($ 3,209.65)

Decision scenario: Eliminate Loan 08 in August, Car loan by December 2003.

Net savings (debt):
Principal owed at 7/31/2004 ($ 37,098.44)
Savings at 7/31/2004 10,060.26
Net savings (debt) ($ 27,038.18)
.
Principal reduction:
At 8/1/2003 $ 60,043.29
At 7/31/2004 37,098.44
Reduction $ 22,944.85
.
Savings effect:
At 7/31/2004 $ 10,060.26
At 8/1/2003 13,990.52
Increase (decrease) ($ 3,930.26)
.
Interest earned (paid):
Interest paid on loans ($ 2,729.40)
Interest earned on savings 180.47
Net interest earned (paid) ($ 2,548.93)

Balance checks / net benefit calculations:

Principal:
Principal (2004) - Base scen. $ 27,698.90
Principal (2004) - Decision $ 27,038.18
Net benefit $ 660.72
.
Principal reduction:
Reduction - Decision scenario $ 22,944.85
Reduction - Base scenario 7,425.47
Difference $ 15,519.38
.
Net savings:
Savings - Base scenario $ 10,060.26
Savings - Decision scenario ( 3,930.26)
Difference $ 14,858.66
.
Principal v. savings:
Principal difference $ 15,519.38
Savings difference $ 14,858.66
Net benefit $ 660.72
.
Interest earned:
Net interest - Base scenario $ 3,209.65
Net interest - Decision scen. $ 2,548.93
Net benefit $ 660.72

Not bad, huh? $660.72 earned earned in twelve months. That's $55.06 SAVED each and every month. What really demonstrates this, though, is total amount paid (principal plus interest):

Base scenario $ 11,063.52
Decision scenario $ 25,674.25
Spending decrease (increase) $ 14,610.73

That $14,610.73 represents the additional cash needed to put this plan in action, which, in turn, returns a gain of $660.72 -- a return on investment of 4.5%!! (660.72 / 14,610.73). Hard to find that return in the market these days! And, seeing my former employer is putting up $10,500 of it, only about $4,100 comes from my pocket -- which, as we complete the circle, is just about what is sitting as "extra" in my e-fund right now.

To summarize, at 7/31/2004, I will have:
* Reduced my debts by an extra $15,500.
* Reduced my debt by a total of nearly $23,000.
* Saved $660 in interest.
* Maintained an emergency fund of $10,000.
* Earned 4.5% on the additional cash investment.

Ain't life grand? :-)


CPAScott
(who realizes that sometimes being an accountant really is fun!)
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