Investing in Index Funds vs. Paying Down Student Loans?

[SAP5243]

Hello all,

I found MMM blog a couple days ago and have been reading it religiously ever since.  I am 22 years old, recent graduate from a public university, and graduated with about $50k in student loans.  Had a few scholarships, but it was overshadowed by the big out-of-state tuition I paid for the first two years in school (I became a resident in my junior year which saved an annual $15k).

As far as my loan goes, here are the approximate amounts and their interest rates:

-Federal:  $11k (3.8%), $3500 (4.5%), $6000 (6.8%)
-Private (WF):  $20k (8.24%)
-Mom:  She paid off about $10k herself, which I will have to repay to her within 10 years.

And also some of my monthly living expenses:

-Housing:  $375 rent, $15 for utilities
-Food:  $50-100 (my girlfriend has food stamps so that helps a lot).
-Phone:  $30
-Eating out:  $50
-Entertainment:  $100-150

I have no car and don't plan to get one anytime soon since Seattle has great public transportation.

I just got a job in the tech industry starting off at about $40k a year with great potential to move up within the first couple years.  My original plan was to buckle down and just pay off this debt within a couple years, but after reading this blog and speaking to my grandpa (who is a very aggressive investor), I'm starting to think that maybe I would be better off investing my money in a Vanguard index fund, particularly the VTSMX, and also maybe some safe individual stocks.

So should I plan to pay down my student loans as quickly as possible, invest in Vanguard index funds (VTSMX), or do a little of both?  I am new to investing so I would appreciate any tips/advice!

[Bruised_Pepper]

Investing (assuming that you're doing this through a 401k or other tax-advantaged account) will let you keep more of your pay by reducing your taxable income than if you use that money to pay off your loans with your post-tax dollars.  But, keeping your debt around to take advantage of this is a risk: what happens if you lose your job?  You can net more money by investing in a tax-deferred account, but you have to keep yourself leveraged to do so.  It's up to you if you can stomach the risk of having debt.

The private loan is obviously the worst one: largest principal, largest interest rate, doesn't have the repayment advantages of federal loans....  No matter what you decide, any extra money you commit to paying these loans down should go to that private loan. 

EDIT: Also, if you do have a 401k, consider at least contributing enough to earn the maximum employer match, even if paying off the loans becomes your highest priority.  That's free money, and you probably won't have to contribute huge portions of your paychecks to get it. 

[dadof4]

Get a little emergency fund together, then aggressively pay down those student loans. The most economical would be from highest APR to lowest. Some prefer the emotional reward of clearing out a loan, so go for that 6k @6.8% first.

With investment, an optimistic view is that you will yield 7% annually if you are stock heavy. With your SL, you are guaranteed to lose more than that.

Investing using loaned money is iffy at 5% APR. At 8.24% it is a very bad (and dangerous) idea.

ETA: The only exception might be 401k till employer match.

[SAP5243]

So sounds like the consensus so far is to pay down that big private loan first before even thinking about touching those index funds?  And to put enough into a 401k account so that the employer will match.

I do have an emergency fund of about $6k saved up right now, which would likely last for at least 3-5 months.  I was just thinking that investing early would be great so that it can continue to grow and compound over time from dividend reinvestments.  I can stomach having debt while investing as long as the investment is likely to pay off in the end, and from reading MMM it sounds like Vanguard VTSMX is the way to go for generally positive returns.

Would it be unwise to invest the initial minimum ($3000), and then start to target my private loan, just so that there's something small in there that can start growing?

[dadof4]

Would it be unwise to invest the initial minimum ($3000), and then start to target my private loan, just so that there's something small in there that can start growing?

Yes, it would be unwise.
The magic that makes your investments grow (compound interest) is being used against you right now - in your loans.  You want to stop the bleeding.

Invest only when you are debt free (or at least when your debt is at much lower APRs).

[SAP5243]

Would it be unwise to invest the initial minimum ($3000), and then start to target my private loan, just so that there's something small in there that can start growing?

Yes, it would be unwise.
The magic that makes your investments grow (compound interest) is being used against you right now - in your loans.  You want to stop the bleeding.

Invest only when you are debt free (or at least when your debt is at much lower APRs).

I guess my grandpa's opinion is that I should let my "assets outlive/outgrow my debts".  The scenario he gave was that if he gave me $50k and I paid off my loans right away, I would have nothing to show for it after.  On the other hand, if I paid the monthly installments w/interest, by the time I paid it off 10 years later I would have more in investment returns and it would continue to grow since it would still be in there.  But I agree with you, stopping the bleeding is definitely important, and the idea of paying an extra $30k in interest is not appealing.

Thank you for your advice!  I apologize if I sound like an idiot, I am new to this "real-world" stuff haha. 

[dadof4]

I guess my grandpa's opinion is that I should let my "assets outlive/outgrow my debts".  The scenario he gave was that if he gave me $50k and I paid off my loans right away, I would have nothing to show for it after.  On the other hand, if I paid the monthly installments w/interest, by the time I paid it off 10 years later I would have more in investment returns and it would continue to grow since it would still be in there.  But I agree with you, stopping the bleeding is definitely important, and the idea of paying an extra $30k in interest is not appealing.

The important thing to look at is net equity: Total assets - total liabilities. You are at negative 50k right now.

If you pay off your loans sooner, at every point in time in the future- in 1 year, in 5 years or in 10 years, your net equity will be higher than if you pay the minimum and invest.

Even in the scenario your Grandpa gave you - if you got 50k right now, you would be 0 equity whether you paid off the loans or kept the money and invested.

Thank you for your advice!  I apologize if I sound like an idiot, I am new to this "real-world" stuff haha. 

No need to apologize. I wish I had asked more questions when I was your age!

Welcome to the forum, and it sounds like you're doing a good job. Living frugally, paying down your debt and then investing will get you to your financials goals.

[SAP5243]

I guess my grandpa's opinion is that I should let my "assets outlive/outgrow my debts".  The scenario he gave was that if he gave me $50k and I paid off my loans right away, I would have nothing to show for it after.  On the other hand, if I paid the monthly installments w/interest, by the time I paid it off 10 years later I would have more in investment returns and it would continue to grow since it would still be in there.  But I agree with you, stopping the bleeding is definitely important, and the idea of paying an extra $30k in interest is not appealing.

The important thing to look at is net equity: Total assets - total liabilities. You are at negative 50k right now.

If you pay off your loans sooner, at every point in time in the future- in 1 year, in 5 years or in 10 years, your net equity will be higher than if you pay the minimum and invest.

Even in the scenario your Grandpa gave you - if you got 50k right now, you would be 0 equity whether you paid off the loans or kept the money and invested.

Thank you for your advice!  I apologize if I sound like an idiot, I am new to this "real-world" stuff haha. 

No need to apologize. I wish I had asked more questions when I was your age!

Welcome to the forum, and it sounds like you're doing a good job. Living frugally, paying down your debt and then investing will get you to your financials goals.

That makes a lot of sense, I appreciate you putting it into perspective.  It's tough being on your own, I have 3 other siblings, one of which who goes to USC, so my parents never could help me much.  I guess the positive thing about it though is that it has taught me to live more frugally and find ways to have fun without busting my wallet like many of my friends do.

Thank you for the warm welcome!

[Mazzinator]

Hello and welcome! Here's my 2 cents for your student loans.

First, i'd put your federal loans on IBR for the interest savings* but you'll have to use the ibr calculator and see if your payments will be less than the monthly interest amount. This "buys" you the next 3 years to focus on paying off the private loans first. Then you can invest more (401k and tIRA), to lower your AGI, which lowers your IBR payments. You can then save up cash to make a lump sum payment to the IBR loans at the end of the 3 yrs, or just pay them off towards the end/by the end of the 3 yrs.

Again, you'll have to crunch the numbers and make sure your fed loans on IBR are way less than the interest per month.

http://studentaid.ed.gov/repay-loans/understand/plans/income-based/calculator

http://www.aie.org/managing-your-money/finance-tools/daily-interest-calculator.cfm

*Interest payment benefit—If your monthly IBR payment amount doesn’t cover the interest that accrues (accumulates) on your loans each month, the government will pay your unpaid accrued interest on your Direct Subsidized Loans or Subsidized Federal Stafford Loans (and on the subsidized portion of your Direct or FFEL Consolidation Loans) for up to three consecutive years from the date you began repaying your loan under IBR.

[SAP5243]

Hello and welcome! Here's my 2 cents for your student loans.

First, i'd put your federal loans on IBR for the interest savings* but you'll have to use the ibr calculator and see if your payments will be less than the monthly interest amount. This "buys" you the next 3 years to focus on paying off the private loans first. Then you can invest more (401k and tIRA), to lower your AGI, which lowers your IBR payments. You can then save up cash to make a lump sum payment to the IBR loans at the end of the 3 yrs, or just pay them off towards the end/by the end of the 3 yrs.

Again, you'll have to crunch the numbers and make sure your fed loans on IBR are way less than the interest per month.

http://studentaid.ed.gov/repay-loans/understand/plans/income-based/calculator

http://www.aie.org/managing-your-money/finance-tools/daily-interest-calculator.cfm

*Interest payment benefit—If your monthly IBR payment amount doesn’t cover the interest that accrues (accumulates) on your loans each month, the government will pay your unpaid accrued interest on your Direct Subsidized Loans or Subsidized Federal Stafford Loans (and on the subsidized portion of your Direct or FFEL Consolidation Loans) for up to three consecutive years from the date you began repaying your loan under IBR.

I didn't even know about the interest payment benefit through IBR, thank you for pointing that out!  I always thought that if you elected to go down the IBR route that you would still have to pay the accrued interest, which means I would end up paying more in the long run.  I had no idea about that 3 year benefit.  I'm going to take a look at the calculator and speak more to family about it and see what they think, and I'll report back with my findings.  Great suggestion!