Advice Wanted: Prioritizing paying off debt or starting an IRA?

[VictoriaH50]

Hi Mustachians! I'm new here and excited to join the community! I heard of FIRE about a year ago and since then I've been listening to podcasts and reading personal finance books. Everything I've learned has blown my mind, and I need to start taking action. I'm just not sure where to focus my efforts.

Here's my big question: Should I direct my money towards paying off my debt or on starting a Roth IRA? (Or maybe I'm asking the wrong question?)

My Situation: I'm 23 years old and I have about $27k in student loan debt. I have no other debts besides that. I really want to pay off that loan debt ASAP so that I can reduce the amount of total interest I pay. However, I also really want to start a Roth IRA ASAP becasue I don't want to miss out on compound interest over time. I'm tempted to focus my efforts on starting the Roth IRA first because based on my income and the math I've done, even if I'm really agressive, it's realistically going to take me around four or five years before I can completely pay off that student loan debt. I didn't do that math, but I know that 5 years of compounding could make a big difference later on down the line when I'm ready to start withdrawing from that Roth IRA. But here's the big kicker- the studen loan is through the federal government and due to the economic impacts from COVID-19, they've said no payments are required and reduced everyone's interest rate to 0% between now and September.They've stated that any payments made during that time will be applied 100% to the principal balance.

Here's what I think I should do: Put as much money as I possibly can toward my loan between now and September to maximize on reducing the principal balance. After that, save up $1000 (which I think is the minimum for Vanguard?) and start a Roth IRA. Then, go back to agressively paying off my loan as quickly as possble.

What do you guys think? Please give me ALL of your advice, thoughts, resources, etc. THANK YOU!!

[JLee]

What is the rate on your student loans?

[terran]

There's a good sticky post at the top of the Investing forum: https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 -- basically, high interest: pay off the debt, low interest: contribute to an IRA. Since you have a temporary interest reduction, use the rate your loans will go back to after that runs out.

[Laura33]

I've seen this type of comment a couple of times, and and honetly, it doesn't make sense to me:  why does the federal government's SL relief create more of an incentive to prioritize paying down the loan now?  Say you have a $300/mo payment, and $270 of that is principle and $30 is interest.*  Yes, if you make a payment now, you are paying $30 more to principle now than you normally would be, which will then save you interest on that extra $30 for the life of the loan (once interest is charged again).  OTOH, if you put that loan payment into the market, you are investing $300 more than you normally would be.  So you are able to deploy 10x the amount of "extra" money by putting it into the market -- and the market is very likely to be what will provide the greatest return over the long term. 

As another illustration, say the market returns a steady 10% this year, and you have 6 months of relief from your SL payments.**  If you take that 6 months to invest in the market, your investment will grow by about 5%.***  But your SL obligation would not grow at all, because everything was suspended.  So on the 180th day, you could sell out of the market, send all of the original payment to your SLs, get the exact same principle reduction on your loans, and still have that 5% in profits in your pocket.  Using my numbers above, that's @$1800 in payments saved up + $90 in earnings.  Now multiply that by 30-40 years in the market, and that extra 5% you started with ends up being a significant amount of money. 

Honestly, if you want to focus on prepaying the loans, put the money in some interest-bearing savings account until the relief ends, then make a lump some payment right before the interest kicks in again.  That way you'll have the cash available if the shit really hits the fan, and if it doesn't, you'll get the same prepayment benefit and have earned a little extra interest on it as well.


*Total WAG, not intended to be real numbers.

**Again, total bullshit made-up numbers for illustration -- the market doesn't actually work like this, and I am not suggesting you should actually do anything like I am about to lay out here.

***Not really, because you'd be putting your money in each month as the market is rising, so you'd buy fewer and fewer shares each month and thus get less than the straight 5% return you'd get if you put all your money in on day 1.

[remizidae]

I've seen this type of comment a couple of times, and and honetly, it doesn't make sense to me:  why does the federal government's SL relief create more of an incentive to prioritize paying down the loan now? 

I agree there's no particular reason to pay off the student loan before September. You'll save money on the interest suspension even if you don't.

OP, how much total cash per year do you have available for investment and debt repayment? In your situation, I'd probably choose BOTH investment and paying off debt. If you can save $1000/month, you could max the Roth IRA with 6k and also make a good start on the debt.

[HotTubes]

I was in this situation (for years) and - for me - the right answer was to have money in the market somewhere.  Just mentally I had to start saving something, even though the better play might have been to pay off my circa 1990s high interest student loans.

If I had it to do over again I would probably put my first 2000/year into Roths, and then pay down debt like a crazy person. And then in January I'd invest until I hit 2000 and then pay debt...

Again, that's not the math/engineer solution, that's a music major trying to keep two balls in the air

[Peachtea]

Given your age and that the loans are all federal, that means they should all be under 5.05%. Probably between 3.76% to 4.46%. And 27k is a reasonable amount of SLs at that interest rate.

I would not make payments during this no-payment time and fill up your emergency fund, if you don’t have one yet, then fill up your Roth or 401k. Do you have a 401k? Is there an employer match? If so make sure you put in enough to get that match before you put into the Roth.

If you wanted to be debt free and could pay it off aggressively in a year or so, I might say go for it. Because I understand the emotional benefit of getting rid of them. But if 5 years is your most aggressive path, that’s too long to wait on retirement contributions. You’d be better off making sure you’re on a 10 year standard plan (rather IDR, so you know it will be paid off by then and don’t have surprise increases) and then dump the rest in investments.

[reeshau]

I really want to pay off that loan debt ASAP so that I can reduce the amount of total interest I pay. However, I also really want to start a Roth IRA ASAP becasue I don't want to miss out on compound interest over time.

All the answers so far have been answers of the head--the logical answers, the calculations--and are correct.  However, since you say you are new to the concept, let me add that it is OK to prioritize the debt payoff *because you want that more*--a heart decision.  It does technically "cost" you something, meaning your net worth is less than its theoretical, optimized maximum.  But we all make choices like that:  to buy a house or not, to take a big vacation, to have kids, to go to a music festival or concert series.  The purpose of being good with your money is to get in the habit of being more in touch with what is important to you, and then directing your resources to that end.  If the student loans cause you anxiety or are "in the way" of some other life goal, it's OK to blast them away before getting on with "routine" things.  But someone who is good with money will be aware of the cost of that heart decision, and will do it willfully, rather than hiding from the truth.

Now, having said that, since you asked:  at the market average 10% return, the market doubles every 7 years.  (7.2 by the rule of 72)  So, 5 years out of the market would cost you a 60% gain on your initial investment.  There are some classic examples of what delays like this can mean to your nest egg, at least in a traditional retirement:

https://realdealretirement.com/how-an-early-start-on-saving-can-get-you-an-extra-250000-or-more/

But understand that if you do intend to retire early, these calculations aren't as critical:  your results depend much more on your savings rate than compounding interest.  If you want to dive into this more, check out:

https://www.mrmoneymustache.com/2012/01/13/the-shockingly-simple-math-behind-early-retirement/
https://earlyretirementnow.com/2017/11/01/shockingly-simple-complicated-random-math-behind-early-retirement/

[Runrooster]

There's a good sticky post at the top of the Investing forum: https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 -- basically, high interest: pay off the debt, low interest: contribute to an IRA. Since you have a temporary interest reduction, use the rate your loans will go back to after that runs out.

This sticky addresses my concern - what about an emergency fund?  Also, is there a 401k match at your job?