Seeking Advice

[Guest SkHi]

I would like to start out saying hi to everyone. This is my first time posting on this site and I wish that I had known this site a couple of years back but anyways, let me start where i stand now. I'm 22, self -employed and out of college with a student loan of 16k, car loan of 8k, and no credit card debt. I have little savings ($4,000) and would like to know is it best I pay off some of the debt before i can start an IRA? Since i'm self-employed; which would be better, SEP IRA or ROTH IRA? Thanks for all the advice..

[John G]

You left out three key items: student loan %, car loan% and current income or spare cash flow. But....

Student loans - these are often very low percent rates and if in the low single digits, do NOT pay off early. Even if they are around 7-8% you should not get excited about paying them off early. All other debt is likely to be more expensive and the loans often are spread over 10 yrs. If you info is vastly different, post again.

Car loans - car loans are normally scheduled to have accelerated interest payments up front, so paying off the loan early often means your average interest rate goes up. You did not mention how many months have past since you started this loan, or the interest rate. Generally, the only great way to buy a car is either with cash, or a bank/credit union loan with more attractive financing terms. If your car loan was arranged through the dealership, it is unlikely that there would be an advantage to prepay. But, again, the devil is in the details. Post again if yours are different.

If you can only fund a retirement account up to the Roth limit, I would be inclined to go the Roth route. Opinions may differ on this, but I like the long term tax free treatment and the simplicity. You can potentially set more aside with other plans... and this is not just SEP/IRA. If you have substantial income (I assume that is less likely due to your age) you might want to see an accountant about a pension/profit sharing plan where you can shelter lots of money.

Loan vs investing? I lean towards ROTH because of what I said above about your specific loans (again, I am guessing on the details) and because you can withdraw the funds short term if you have a problem.

The biggest problem I see with your situation is that you have very little "contigency" money. If you have an accident, medical setback, downturn in employment, or start an expensive campaign for the heart of another.... you have very little in reserve. This is very common for someone your age, but you should also put building up your reserve as a priority. To some extent, you can use the ROTH for this purpose since you can always withdraw your contributions.

If you post again - provide more info such as loan percent rates, duration of loans, marital status, how much spare cash you have to dedicate to investments, etc. I congratulate you on zero credit card debt - you want to keep it that way. Credit card balances are foolish and often reflect on a lack of knowledge or discipline. {PS: I am curious about your academic degree and current occupation. We don't get a lot of entreprenaurial people posting here.}

[Guest SkHi]

Thanks John G for a quik response. I took out a student loan when i was at a major university but decided to change major and drop out and went to a community college instead. My student loan is at 6.2% and car loan is at 8%. I bought the car back in 2002 and finance it for 5 yrs. I've been paying more than the minimum for the past 2 yrs and hopefully pay it off end of this year. I wish that I would have bought a used car instead but oh well, lesson learn. My income is from landscaping and vary from season. Four months of winter, my income avg around 2.5k while spring and summer, 3.5k+. I'm single and rent a duplex with a friend. I have 4K to invest and at least 2k in the bank. From what I understand from your post, ROTH IRA is the way to go? Should I open a ROTH anytime or is there a certain date to open (deadline)? The 2K in the bank, is for reserve but i would like to invest in some where else rather than a saving account, any suggestion? THanks

[John G]

Lessons learned - new vs used ! Yep, it is nice not to have all those car payments. Some folks never really learn that lesson, so a plus for realizing it now. Accelerating your car payments is not likely to buy you much because the interest scheduling on auto loans is heavily front weighted. Do it only if you want to erase an annoying decision.

School loan - This is a medium level interest rate. I would not speed up this repayment if you then racked up any other debts because they will be a higher rates. Call this purely discretionary - you can repay early if it irks you or you think you would spend the money otherwise.

Given the amount of income you have, yes, I would suggest a Roth as you probably can fully fund it each year. As your business develops and if your income increases, you may want to investigate other options such as a pension profit sharing plan (if you are incorporated, with or without employees) where you can potentially shelter more than 4k. This Roth should be the foundation of your investment plan and try to fully fund it - - which is likely to make you a millionaire in your 60s if you can stick with the plan! If you have additional funds after funding your Roth, then I would suggest four possible directions: (1) plough money into your business to grow, add services or increase profit margins, (2) increase your "contingency" funds, (3) accumulate funds for a down payment on your first house, and/or (4) start non-retirement investing in perhaps another mutual fund.

Which comes first or second and the timing is heavily related to your cash flow and business success. Stop by your local library and pick up a copy of the "Millionaire Next Door".... this is a very dry book, but it gives some interesting insight into how many folks become wealthy by "playing good defense" (controlling spending) and the role of business ownership.

There is no best date to open a Roth. All things being equal, earlier is better because your money is in the tax shelter longer. One option to consider is to establish a automatic monthly deduction from your checking account. This means that every month a fixed amount goes into your Roth. On months when the stock market dips, you buy more shares. The concept is called "dollar cost averaging". If you can't fully fund your Roth up front (early January) of each year, then consider the monthly plan. An automatic deposit committs you to your plan and cuts down on your paperwork. I would set a goal of getting your 2005 Roth opened this month.... beat the year end and tax season rush.

The 2K could be put into a short term CD to get a better yield, but it is such a modest amount that it is perhaps best left in a simple savings account. As you build up your contingency fund, you can "ladder" CDs, that is have multiple overlaping CDs with different expirations, so that in any 3 months or 6 months some cash would become available.

As an entrepeneur, I would recommend that you focus on growing your new business. You will find lots of opportunities to add products, expand you territory, or move to higher margins. At some point, you need to also think about your personal medical coverage, perhaps some kind of disability protection.

Good luck.

[Guest SkHi]

Thank You John G. I really appreciate the advices that you gave. Thank you!