Personal Finance Primer – Part 2
July 29, 2016 | Olivia Hung, MD, PhD
In Part 1, I discussed the basics of personal finance, including securing and protecting our earnings potential and current financial independence. Once these have been considered and acted upon, the next step is arguably more individualized, making it more complex and interesting. People who have budget surpluses can now plan to use that surplus in one of the following four general categories.
- Spend it. Through college, medical school, residency, and now fellowship, we have become very good at delayed gratification. Yet at some point we do want to feel like we’ve made it, and even a small surplus in our budget could be tempting for a splurge. Regardless of whether it is dining out, tickets to the latest Beyoncé concert or hiring a housekeeper (no more scrubbing toilets on those precious days off!), once you spend it, it’ll be hard to get that money back.
- Keep it in Cash. We discussed the concept of the emergency fund in the first post. At that time I recommended a minimum of three months of living expenses. This was an absolute minimum, and it may be worth growing that fund to cover six to 12 months of expenses for increased peace of mind. Most of us would also like to own a home, which requires a significant amount of cash for a down payment. On the other hand, bank account interest rates are at record lows, raising the risk of inflation reducing purchasing power. Some would argue that you might as well have spent that surplus. What good is saving today’s money for an ice cream cone if you can’t buy that same ice cream cone tomorrow?
- Pay Down Debt. The average U.S. medical school graduate has a six-figure education loan and possibly other debt as well. Using the surplus to pay down debt makes you feel happier as you watch your debt shrink and guarantees you a specific rate of return. For example, the federal Stafford loan has a 6.8 percent simple interest rate. If you funnel money to this loan, then you are guaranteed a yield of 6.8 percent. This beats the <1 percent bank account interest rate at the cost of liquidity. Whether stock market returns can beat a guaranteed yield depends on your perspective on stocks.
- Put it in Stocks.The financial pundits argue that the stock market historically records more gains than bonds. This is the riskiest option and the actual rate of return depends on which time period the money is actually in the stock market. For example, the S&P 500 over the past 10 years (2007-2016) returned about 35-40 percent. This period included the last hurrah of the housing boom, the Great Recession, the subsequent bull market, and the recent turbulence of the stock market. On average, this translates to about 3-4 percent annual yield which, though significantly lower than the advertised 10 percent average annual return, does still beat inflation. Nonetheless, if one has loans with high rates (e.g., federal Stafford loans are 6.8 percent), loan payments may prove more prudent as it is difficult to guarantee stock market returns that are significantly higher than those interest rates.
For house staff, there are three options: 1) workplace-sponsored retirement savings accounts (regular or Roth 401(k) or 403(b)), 2) personal retirement accounts (MyRA, regular IRA and Roth IRA), or 3) a regular brokerage account. The retirement accounts have tax advantages compared to a regular brokerage account, but do have annual contribution limits ($18,000 for 401(k) and $5,500 for IRA) and other rules about company matching and vesting, investment options and account portability. The Roth versions of the retirement accounts tend to be recommended for people in our situation – those who expect to earn more in the future (and thus be in a higher tax bracket) than they do currently. Additionally, I have found the Roth IRA to be more flexible as one can withdraw contributions penalty-free after five years.
What you ultimately choose to do with a budget surplus is up to you, and will likely end up a mix of the above four options. How much to allocate to each bucket depends on your own situation. I hope this primer provides a useful perspective on things to consider during one’s early stages of financial planning and independence.
Read “Personal Finance Primer – Part 1” here.
This post was authored by Olivia Hung, MD, PhD, a fellow in training at Emory University Hospital in Atlanta, Georgia.