What to do with my debts?

Question: I got my bachelor's in studio art in 2007. Now I'm 26 and have been out of school and paying off 2 student loans for nearly 3 years. The balance of one loan is currently $3,998.06 at 2.470% interest. The second is $8,575.80 at 2.875%. I'm on track to have them paid in a little over 7 years. I also own some mutual funds that are currently at $29,000. The mutual funds took about a 30% dip two years ago in the stock market fall, but now they're $1000 away from amounting to their original cost, $30,000. I'm an artist with an office day job and usually pretty strapped when it comes to month to month income. I have no regular savings. My question is whether to pay off my loans from the funds in order to be debt-free, have more income each month to spend, save, or re-invest, and stop adding to my long-term loan balance by incurring interest. I've been reluctant to sell, though, without knowing more - I'm rather ignorant about the financial world, and still really sorting out potential career/earnings prospects. Might it be better for my long term financial future to get out of debt now, or to hold onto the full amount of these investments? Thanks, Sarah, Portland, OR

Answer: I would pay down all or most of the debt by cashing in a part of your portfolio. Key to my recommendation are two factors. The first factor is that you're going to try to succeed as an artist over the next several years. The second point is that you'll take advantage of being debt free to build up your stash of safe savings. Money will remain tight for some time.

Here's my reasoning: You have a fraction over $12,573 in total student loan debt at an attractive interest rate. If you knew that you were going to change careers and start earning a better, steady income within the next yer or two then I would say, hold off on doing anything until you have a clearer picture of your future job choices.

But your note strongly suggests that your overriding goal is to make it as an artist or, at least, to give it a try. Yes, you have an income from your day job to pay the bills, but your passion is pursuing an artistic career. If that's the case, considering the costs associated with creating art and the uncertain income from selling art it's critical that you build up a healthy financial cushion.

You could sell enough stock to get out of debt or almost out of debt. Yo would still have a nice chunk of long-term savings. The taxes on the stock sale should be low, since it appears you're in a low tax bracket. You've also owned the stock for more than a year. That means you get to take advantage of the low long-term capital gains tax rate.

However, once the debt is gone I would focus on adding to savings, perhaps in a savings account, short-term certificates of deposit, and the like. You don't want to carry any risk with this savings (so dn't put it back into stocks). The reason is that you want a financial anchor to offset the risk inherent in your job as an artist. You won't earn much interest on the savings, but so what? The money will be there when you need it.

You'll need to live frugally to reap the money you'll need to add to your savings accounts. As you become more successful as an artist the combination of a savings cushion and frugal living will allow you to smooth out your income over the course of a year. And, if you eventualy end up deciding on another path, you'l have the money to fund that transition.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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