Is my debt an emergency?

[Stone11]

Hi all,

I have boiled my question down to this:

I have two large debts and would like your input as to whether they constitute a "debt emergency" that requires my immediate attention or if I should focus first on maxing-out my investments before putting any extra money towards the debts. 

(1) Mortgage - about $135k at 4.25% interest.  Based on my review of the site, it seems most are of the opinion that I should opt to invest extra funds rather than pay down the mortgage at this interest rate.

(2) Student Loans - about $145K at 8.25% (law school).  I am five years in and am paying the loan back via the government's income-based repayment plan.  This cuts my monthly payment to about 1/4 to 1/3 of what I would be paying if I chose to pay it back in ten-years.  Under the income based repayment plan that was available when I graduated, I am required to pay 15% of my discretionary income per month, so obviously the amount I am to pay fluctuates with my income, but my monthly payment will never exceed what I would pay monthly under a standard 10-year loan repayment.  Additionally, the entire balance of my loan is forgiven after 25 years (20 years from now).  However, the forgiveness of the loan is treated as income during the tax year in which it is forgiven. 

So, given the two loans I have right now, should I put all my extra money towards maxing out my IRA, 401(k), and HSA or is my debt an emergency that I should prioritize paying off over saving (moral issues of repaying full loan amounts aside)?

Thanks in advance for your thoughts.

[Nick_Miller]

Yes the student loans are a HUGE emergency, both because of the amount and the rate. I'd get ready to punch those in the face. You don't want student loans when you're 50.

What's your income? Expenses? If you posted a case study, I'm sure folks would help you find cuts to make.

[AlanStache]

Yeah that is a huge student loan.  But do the math, what will you likely have paid towards it over the 25 years + taxes on the balance in the last year?  Do you intend to make more so that the min payment will go up?  If you really went after the 145k what would you end up paying total?  Post some math with a few different sets of assumptions see what the numbers say.

[LeRainDrop]

(1)  Mortgage of about $135k at 4.25% interest - No, not a debt emergency.

(2)  Student loans (law school) of about $145K at 8.25% - Yes, this is a debt emergency.  IIRC, I started with about $125k debt out of law school, I maxed my 401(k) each year, bought a condo three years out of school, and finished paying off the loans in my fourth year of practice.  I am very glad that I maxed the retirement savings each year even though I was still paying off the loans.  So, yes, the retirement savings right out of the gate (and especially the condo purchase) delayed me from paying off the student loans even earlier, but I still think it's worth it for you to keep contributing to your retirement simultaneous with paying down the student loans.  Other than that retirement savings (and having an emergency fund), I would treat the student loans as a fire to put out.

[Stone11]

I am 31 and only make $77k a year, so paying off the student loan in a few years seems out of reach.  If I attempted to pay it off in the next 5-7 years, I would get really behind on any investment accounts.

At my current income, I only pay about $550/month via the income based plan (my last $5k raise only bumped my monthly about $30/month). With some quick dirty math, if I tried to pay it off in 10 years, I would be paying about $1,700/month.  My hunch is that there is a big enough gap in these amounts that I would probably be better off utilizing the forgiveness plan while continuing to max my retirement accounts.  I am not expecting a big pay bump anytime soon.

I should also say I get a $2,500 deduction for student loan interest paid every year as well on my taxes.

[LeRainDrop]

Oh, in that case, sounds like you've already resolved your answer to your question.

[MDM]

I am 31 and...make $77k a year...[and]...I get a $2,500 deduction for student loan interest paid every year as well on my taxes.

Based on those numbers, you may be either
 - single and contributing $12K or more to a 401k or similar, or
 - married

If single, you could pay the SL off in 10 years, continue to pay the mortgage and put $12K/yr into your 401k, pay federal income tax and FICA, and still have $21K/yr for state and property taxes and other expenses.  Doable for a single person.

If married with a non-working spouse and no kids, you could pay the SL off in 10 years, continue to pay the mortgage and put $12K/yr into your 401k, pay federal income tax and FICA, and still have $24.5K/yr for state and property taxes and other expenses.  Still doable.

Of course, other permutations are possible.  How does that look to you?

[csdreaming]

Once your income rises to a point the student interest loan deduction is phased out. You are really near it.

Do you work for a government or qualified nonprofit? I believe you can't get the loan forgiveness without working for one.

I believe the repayment plan is based on AGI so 401k contributions help you in that regard. I don't know if the debt qualifies as no retirement contributions emergency. But certainly a no eating out or buying shit emergency.

[PowerMustache]

(EDITED FOR CLARITY)

I put together a spreadsheet to do a comparison of two scenarios: Stick with IBR, or aggressively pay down your student loan (mortgage is not an emergency). It is rough with lots of not-quite-right approximations and assumptions about your situation, but it looks to me as though you'd be better off if you aggressively pay off the loans.

https://docs.google.com/spreadsheets/d/1f_e0fZ0fMQtpiDzBlQKPuwHMTdMeJVyR_BW-yrrvwLQ/edit?usp=sharing

If I were you, I would make another spreadsheet with more details/better approximations with your real numbers. Feel free to start with mine and build on it -- you can make a private copy for yourself so you don't put all your details out there publicly. If you're not fluent working with spreadsheets, google around or ask questions here and you'll probably get help from me or others.

If you assume that your salary will grow at 2% above inflation over the next 20 years and your annual living expenses are $30,000, your total net cost under IBR would be $274,000 and your total net cost aggressively paying down would be $209,000. You would come out about $65,000 ahead by using all of your expenses beyond basic living expenses to pay down your student loan, and you would pay it off in 9 years. This also assumes you will max out your 401k in both cases, IBR and aggressive loan paydown. Play with the assumptions and see what you find, try some other scenarios. I made this spreadsheet quickly so it may contain errors.

[Paul der Krake]

There was a great thread last year about the implications of using income-based repayment programs. The argument got quite heated but many aspects were discussed. You might want to give it a read.



It sounds like you are right in the middle, with no clear winner given current numbers. In those situations, you would be wise to pick the one that gives you the most control.

[PowerMustache]

As expected, I found some problems in my spreadsheet already. After accounting for the fact that you would likely invest all your excess money over the 20 years, the picture gets a lot less clear. Probably want to go to that other thread for details. In my spreadsheet, the winning scenario is highly dependent on your expected salary growth rate as well as expected return on invested money.

[nereo]

Stone11 - Have you looked into refinancing those loan?  Others have managed to refinance loans similar to yours at <5% for a 10year note.  That will drastically shift the 'optimal path'.

Get some quotes from SoFI and similar places and report back.

[Dezrah]

This advice is based on my experience with our student loans which were all Federally backed and consolidated by the time I dived in.  I'm making assumptions that may or may not apply to your loans.

I realized that our loans were accruing interest daily but were not compounding.  That meant the loan would grow linearly but not exponentially.  This gives the "invest" option a little more weight the longer your timeframe.

Furthermore, each payment would go toward the interest first and would only pay down the principal if the payment exceeded the accrued interest.  If you've been on a special payment plan, there's a good chance your reduced payments aren't breaking through that interest barrier.  If that is the case, there is no reason to pay more than your required minimum until you can pay off all the accrued interest and then some.  Remember the interest is NOT compounding on itself.

If your interest balance is high, your best option would be to start a sinking fund in a simple saving account (or even a low risk investment account if your timeframe is long enough) with the purpose of paying off the loan.  When you finally save the interest balance, pay it off in one fell swoop and make all future payments to the lender.  You're still working hard to pay off the loan, but if the shit hits the fan, that money is there for you instead of in the bank's pocket and in the meantime you've lost nothing.

Be careful about refinancing and seriously run your numbers. If I understand correctly, this will result in resetting the entire amount as principal. 

(Made up numbers here.)  Would it be better to have $100k principal at 8.25%, $45k interest @ 0%, and use the sinking fund?  Or would it be better to have $145k @ 5% and start paying down principal immediately?  Will the new lender allow you the same tax benefits, disability forgiveness, emergency IBR structure?

Whatever you do though, remember all that really matters is how your Net Worth changes over time.  Yes there are ways to optimize your growth, but the single most important factor is whether or not you choose to spend.

[Slee_stack]

8.25% as a loan rate is painful for me to process.

I wouldn't suggest anybody try to beat that by investing your money instead.  Even though you are young, that's just too high a rate to expect to beat consistently.

Since SLs are nearly impossible to discharge, I don't see much in the way of options beyond attacking that balance as much as you can.

Regardless, if you can refinance at a lower rate, do it as quickly as you can.

[TrulyStashin]

I had a similar amount of SL debt upon graduation from law school in 2011.  At first, I made the regular payment amount of about $1100/ month.  I was not Mustachian then and decided that was too hard so I shifted to IBR and dropped my payment significantly.  A couple of years went by and I had not made ANY progress (duh) and when I finally forced myself to look at the principal amount, it had gone up by about $12k since I had graduated.  I owed $159k!!!  Wow, what a horrible face punch moment.

In 2013, I found this site and realized how big a crisis I faced.  I did a 180 on a bunch of choices. 

In late 2014, I refinanced with SoFi and dropped my rate by almost half. My payment was $1538 with about $1000 of that going to principal. Finally, I started making progress.  My payment is now $1700/ month which is largely due to the fact that I took a 6-month break last year -- SoFi let me pay interest only -- so I could start my own law firm.  At this point, about $500 of my payment goes to interest with the other $1200 going to principal.   I now owe just over $142k  which is just below where I started at graduation.  (Note:  this would be down to about $134k if I had not taken a break from Sept. '15 to April '16 when I started my law firm.  I paid interest-only during that time).

Everyone on IBR is gambling on future government policy matching what's offered today and you are captive to that loan for 20 years.  I am not a fan and my experience is a cautionary tale, IMHO.

You could either refinance to drop your rate and suck up a higher payment.  Here's my referral link if you're interested:  http://www.sofi.com/refer/426/790  Or you could stay on IBR but throw every spare $1 toward the loan principal with supplemental payments.

Oh, I contributed to my 401k just enough to get the maximum employer match and otherwise threw all my money at my debt. 

Check this out for inspiration:  https://nomoreharvarddebt.com/

[frugaliknowit]

8.25% as a loan rate is painful for me to process.

I wouldn't suggest anybody try to beat that by investing your money instead.  Even though you are young, that's just too high a rate to expect to beat consistently.

Since SLs are nearly impossible to discharge, I don't see much in the way of options beyond attacking that balance as much as you can.

Regardless, if you can refinance at a lower rate, do it as quickly as you can.

Ditto.  This hurdle is SKY HIGH!!

[Bajadoc]

I felt a bit lightheaded when I saw the student loan interest. Definitely something to be addressed as soon as possible.

[marty998]

IBR sounds like a sneaky way for student loan providers to maximise their returns on investment.

I mean... in what other field of lending can you give a loan repayable over 25 years, but your monthly payments are not sufficient to actually pay down the loan? And then they get the taxpayer to bail out the lender at the end.

Win/win. I need to get into the business of offering 17 year olds education loans...

[Stone11]

Thanks for the thoughts everyone.

IBR is available to those who do not work in government/non-profit jobs, but the length of the loan until forgiveness is much shorter if you are in government/non-profit (10 years I believe).

If I decide to go after the loan, I will likely consolidate and refinance.

My monthly payments are not touching the principal, but the interest  does not compound.
 
While I understand wanting control over my debt  and being able to shed it in 8 years versus another 20, I’m still hesitant for a few reasons:  (1)  paying the loan back will kill my retirement investment for those 8 years, (2) I believe refinancing the loan will include the current interest in the new loan principal; (3) if I consolidate and refinance at a better rate, I lose the ability to go back to IBR and (4) if I lose my job, change careers, become disabled, etc., then having the IBR option would be nice over the monthly payment of a standard loan. 

The other IBR thread was useful.  It seems most of the opposition was being voiced by a few people who hated the idea of the government program and were against using it for moral and emotional reasons.  I didn’t see much criticism of it on the financial side, although the OP of that thread made about $45k, so it was a clearer case for taking the IBR route than my situation.

Another point that I didn’t mention regarding IBR is that the IBR monthly payment is calculated on AGI, so maxing out my investment accounts also lowers my monthly payment.

Also, if I lose my job, it is likely that my monthly payments would drop to 0 and I would still be making progress towards the 20 years I have left on the loan.   I guess it is even technically possible to achieve FIRE with money still owed on the loan, just with making $0 monthly payments during retirement.  Then, the only debt would be related to the loan forgiveness in year 25.  And, although I do not expect it to happen, there is still an outside chance congress will try to exempt student loan forgiveness from being treated as taxable income.