Pay down student loans or invest?

[sandiahiker]

My wife and I just started reading MMM a couple weeks ago and are hooked!  We're both in our late 30s and have been doing pretty well, but reading MMM has opened up a whole new world to us!

Here are our particulars:

• no kids, but are trying to change that :)
• income around $72k (after taxes) - although it has only been that for the past four years.  Before that we were earning much less.
• our only debt is $45k in student loans at 2.75% (payment is $315 month, so a maximum of 15 years and $10k of interest left.  Using the student loan tax deduction, this insterest is reduced to about $7500 over those 15 years, so an effective interest rate of around 2.2%. I think I did that math right, but correct me if I'm wrong!)
• Have maxed out our Roth the last four years ($40k)
• Renting our house due to volatile job situation (no 401k or employee-provided health insurance available)
• $70k rainy day fund (not earning anything due to my over-cautiousness)
• about $100k in several investments from an inheritance
• our expenses for the last four years (before discovering MMM!) were $5k/month
• Only own one car (2004 Toyota Matrix) and live 4 miles to our primary employment

My basic question is should we use some of our rainy day fund to pay off all or a portion of our student loan.  I understand that the general answer is that since a person can generally earn more than 2.75% investing, we should keep our debt, and invest the money that would otherwise go toward paying off that debt.  But is there anything in our particulars that screams "DON'T DO THAT!?"

Thanks for all your help!
Mark

[plainjane]

• our only debt is $45k in student loans at 2.75% (payment is $315 month, so a maximum of 15 years and $10k of interest left.  Using the student loan tax deduction, this insterest is reduced to about $7500 over those 15 years, so an effective interest rate of around 2.2%. I think I did that math right, but correct me if I'm wrong!)
• Renting our house due to volatile job situation (no 401k or employee-provided health insurance available)
• $70k rainy day fund (not earning anything due to my over-cautiousness)

My basic question is should we use some of our rainy day fund to pay off all or a portion of our student loan.  I understand that the general answer is that since a person can generally earn more than 2.75% investing, we should keep our debt, and invest the money that would otherwise go toward paying off that debt.  But is there anything in our particulars that screams "DON'T DO THAT!?"

If you have a volatile job situation, there is an argument for keeping that 70k liquid so you can use it to cover expenses (including the loan) if something goes wrong with the job.  However, if it isn't earning anything, I think shifting some of it to the loan makes a lot of sense.  How many months does 70k cover?  How long would it take to replace your job?

A 25k emergency fund is generally considered quite good.  And mathematically it puts you ahead.  Don't compare to what you could be making in the market vs. the 2.75% - you don't have the money in the market.  Your comparison is 2.75% guaranteed vs. whatever you are making in interest on that 70k.  And this doesn't wipe your emergency fund out.  Given what you've said about cautiousness, I think it makes sense to get rid of the debt.

[sandiahiker]

I should also add that one year from now the job situation could very likely become more stable, prompting us to possibly want to buy a house, at which time part of the $70k rainy day fund could be used as a down payment.

Thanks for the advice so far!

Mark

[Lackland]

• our only debt is $45k in student loans at 2.75% (payment is $315 month, so a maximum of 15 years and $10k of interest left.  Using the student loan tax deduction, this insterest is reduced to about $7500 over those 15 years, so an effective interest rate of around 2.2%. I think I did that math right, but correct me if I'm wrong!)

Okay, checking your math! I think you're off a bit.

- The difference between a deduction and a credit. A credit would give you $2,500 off your entire final tax bill dollar-for-dollar. A deduction removes only part of your taxable income from eligibility for taxation, and the amount you get back is dependent on where your income falls across the tax brackets. $72K filing jointly puts you on the border of the 15%-25% brackets. With the standard deduction, you'll be down to the 15% bracket. This just means that $2500 of your income won't be taxed at 15%. You only get $2500 x .15 = $375.
- Because this is a fixed-payment loan, the amount of interest one pays each month decreases. Right now, based on the numbers you gave ($45000 in principal, with 2.75% interest and a $315 payment), I think you're only paying $103 in interest per payment. This year, if I'm using Excel correctly, you've only paid about $1300 in interest, so you'll owe Uncle Sam $180 less. In the far future, say year 14, you'll pay the last ~$65 in interest for $10 off your taxes. Your cumulative interest paid on this loan will be about $10,000, but your tax savings will be less than $1500, with most of that coming to you in the next six years. Your effective interest rate is like 2.3375%.
- If your income goes up in the future past $125K, the deduction is prorated, so it's an even worse deal.

That said...
- Not sure if your "after tax" income is your take-home pay or not; if your gross is higher than I'm thinking, then some or all of the deduction could wind up in the 25% bracket, at which you actually are getting $2500 total over the course of the fifteen years.
- Still, this is a SUPER LOW rate. An investment of $45K over the same fifteen years would get you a lot more than what you'll spend on interest--a 5% rate would get you to $93K before taxes.
- If you want to see how paying down the loan would affect the total interest, take a look at this loan interest calculator:
http://asksasha.com/loan-interest-calculator.html

[sandiahiker]

Okay, checking your math! I think you're off a bit.

- Not sure if your "after tax" income is your take-home pay or not; if your gross is higher than I'm thinking, then some or all of the deduction could wind up in the 25% bracket, at which you actually are getting $2500 total over the course of the fifteen years.

Thanks for the help!

The "after tax" is more or less the take-home pay.  It's our gross income minus our our tax payments that we've averaged over the last four years.  Our work is somewhat seasonal, and comes from a variety of sources, so I can't just look at one pay stub and say "this is my take-home pay."

We are right on the cusp of the 15-25% bracket.  I think our taxable income last year was about $60k (after deductions from things like the standard deduction, student loan interest, and our HSA), so it is indeed hard to know if the deduction is occuring at the 15% level or the 25% level.

Mark

[prof61820]

Is your student loan interest rate variable?

[sandiahiker]

Is your student loan interest rate variable?

Nope.  Fixed at 2.75%.

[Khan]

I'd strongly recommend doing -something- with that 70k dollars. Here's what I'd recommend if you really want to be cautious while still getting at least some utility out of it:

-Leave ~10k-15k as emergency stash
-Place next ~20k in rotating CD's with rotating maturity dates that auto renew so you'd always have access to some amount of that money coming up in the next couple of months, there, you've partly attacked the inflation eating into this stash.
-Have credit cards? Depending on your own biases, you could consider your credit limit as part of your "emergency stash".
-Place the other ~40k in a taxable investing account, and take your pick of ETF's to invest in. In what state(taxable, ROTH, etc) is the inheritance currently in? Letting us know that would help with giving you options.

The student loans are really attractive at that interest rate, it's extremely hard to make the argument to pay them down over attempting to get a better rate elsewhere, and then you also have the freedom of having that money available to you.

[madmax]

iBonds are also an option if you do want to do something with the money. However, it seems like 70K is slightly more than one year of living expenses for you and given your volatile job situation, I wouldn't touch it. 5K/month seems really high for a 72K income, anything you can do to get the expenses down?

[chasesfish]

Is that 100k in "various investments" liquid, like stocks and bonds?  If so, I'd probably payoff the student loans.

[sandiahiker]

Is that 100k in "various investments" liquid, like stocks and bonds?  If so, I'd probably payoff the student loans.

Yes, the 100k is relatively liquid, and could be used in a rainy-day fashion, I suppose.  Good point.  Right now we are leaning toward paying off the loan, mainly for the uncomplicated, stress-free way it would save us $8-10k over the next ten years.   And we like the idea of being suddenly debt-free.

A previous poster mentioned using credit cards in an emergency.  I guess if it came to that, we could, as between our two cards we have close to a $30k limit, but at the usual 18-20% that sounds horrendous.  Just to clarify, we have no credit card debt right now.

iBonds are also an option if you do want to do something with the money. However, it seems like 70K is slightly more than one year of living expenses for you and given your volatile job situation, I wouldn't touch it. 5K/month seems really high for a 72K income, anything you can do to get the expenses down?

Keep in mind the $72k is take-home, so we are saving that $12k difference each year, but we are definitely getting our expenses down right now.  Planning on reducing to 4k, possibly less if we can muster it up.

Thanks everyone, and keep the advice coming, though!

[Nancy]

With a fixed interest rate that low, I would definitely not pay off that loan faster than the normal payment period. I would invest the money in something that will likely earn more over the long run.

[sandiahiker]

In what state(taxable, ROTH, etc) is the inheritance currently in? Letting us know that would help with giving you options.

The student loans are really attractive at that interest rate, it's extremely hard to make the argument to pay them down over attempting to get a better rate elsewhere, and then you also have the freedom of having that money available to you.

So I finally was able to speak with our "guy" about our investments.  Here's where we are with our inheritance and Roth IRAs.

• Roths (one for me, one for my wife): Metlife Variable Annuity (Series VA) with 5% guaranteed growth - about $23k each.  This is where our $40k of Roth contributions have gone for the past four years.
• Metlife Variable Annuity (Series L) with 6% guaranteed growth - $37k
• Pacific Life retirement restricted (59.5) annuity: $28k
• Genworth account of various funds (I guess), totally liquid: 32k

I'm not really sure why our "guy" sold us so many annuities.  I thought we were investing, but it seems we are just buying insurance policies.  Maybe we seemed really risk-averse, and before the last month or so, I really didn't understand any of this, so my wife and I were blindly giving him money.  I still don't really understand these annuity things, but it seems like the fees are somewhere in the 2.5% range.

After reading more about annuities, I kinda want to get out of all of them, with their high fees and high complexity.  Switching to some simple Vanguard funds (Target Retirement, for example) seems very attractive to me.

For withdrawal fees, the Metlife Series L is free and clear starting in January, the two Series VA Roths will drop down to $1860 (total) in April, and we are looking into the Pacific Life.  We're guessing that is free and clear (not counting IRS stipulations) since it has been many years since we contributed anything to it. 

Our guy is also recommending to pay off the loan.  Anyway, armed with this new info, what do you all think? 

[Greenbeard]

I'm not really sure why our "guy" sold us so many annuities.  I thought we were investing, but it seems we are just buying insurance policies.  Maybe we seemed really risk-averse, and before the last month or so, I really didn't understand any of this, so my wife and I were blindly giving him money.  I still don't really understand these annuity things, but it seems like the fees are somewhere in the 2.5% range.

In my experience there are some subtle titles in the financial industry that people should be aware of:

They say: Free financial adviser
They mean: Insurance salesman

They say: Estate planning attorney
They mean: Insurance salesman

Here's the only free investing advice you'll ever need:

1. Open a Vanguard account.
2. Chose your acceptable risk/reward level (personal choice).
3. Buy Vanguard funds that give you your desired asset mix.
4. If someone tries to sell you annuities kick them in the crotch and run like hell.

If you don't like Vanguard for some reason, chose funds with the lowest fees and loads elsewhere that will give you your desired asset mix.