Author Topic: Low interest student loans or invest in taxable account?  (Read 2343 times)

csnerd

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Low interest student loans or invest in taxable account?
« on: April 24, 2016, 10:49:12 AM »
Hello there fellow Mustachians, I am a 22 year old living in a low COL city and I am debating on whether to pay off my low interest rate loans or to invest in a brokerage. Some quick facts about me:
Income: 77k
Roth IRA: 16.5k (already maxed for 2016)
401(k): 4k (set to max out to 18k for 2016)
HSA: 1k (set to max out to ~3100 for 2016)

Debts:
Have a new car with 19k left on it at 2% interest over 5 years
Student Loans (All 10 year loans):
2200 at 4.29%
3500 at 3.86%
4500 at 3.4%
another 4500 at 3.4%

I have 4 months worth of expenses in an emergency fund earning 1%.

Credit score: 780

I see a few options here: put all extra cash flow towards the loans and be done with them, pay the minimum amount since they're low interest and I can deduct the interest on taxes and instead invest in a brokerage, or some other mix. The loans will enter repayment in June/July and only the 2nd and 3rd loans are gathering interest right now. I have already paid them down to ~14,800 from the ~23k I owed since December just because I wanted to at least knock out "some" of the higher interest ones even though they were at like 4.6% themselves. I want to be FI by 35-40. Would you continue to invest or pay back loans if you were in my situation?
« Last Edit: April 24, 2016, 11:13:48 AM by csnerd »

sparkytheop

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Re: Low interest student loans or invest in taxable account?
« Reply #1 on: April 24, 2016, 11:07:22 AM »
Personally, I would do a mix.

Pay off the 4.29% loan now, or as soon as it starts requiring interest payments.

Do you have enough deductibles to actually deduct the student loan interest?  If you take the standard deduction, that wouldn't be a consideration for keeping them (but, I've had Schedule A deductions since I was 19, not sure you can take them without that, and other factors that go with it--house, dependent, etc.)

What is the payoff time for the rest?  I might not try hard to pay them off, but I'd round up the minimum payment and make sure the extra is going to principle.

Then I'd start investing with the rest.

Other factors that may influence things-- do you plan to buy a home?  What is your credit score like if you do? 

Sounds like you're off to a great start!  Starting young is a huge factor when it comes to compound interest.


csnerd

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Re: Low interest student loans or invest in taxable account?
« Reply #2 on: April 24, 2016, 11:15:18 AM »
Hi, I've updated the original post with the loan time spans and credit score. I thought that a traditional 401(k) and HSA lower your MAGI so that it would be low enough to get the student loan interest deduction.

Bracken_Joy

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Re: Low interest student loans or invest in taxable account?
« Reply #3 on: April 24, 2016, 11:33:02 AM »
I would sit on the sub-4% loans. My only question would be that 4.29%, and I think that comes down to how risk tolerant you are. Personally, I am planning to sit on all my loans below 5% (which I just achieved paying off all others this week! Woo).

The breakdown I've always seen (thanks MDM):
Note: current treasury note yield is 1.89, so that would be 2: 6.89%, 7: 4.89%
Quote
WHAT
0. Establish an emergency fund to your satisfaction
1. Contribute to 401k up to any company match
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.
3. Max HSA
4. Max Roth or Traditional IRA based on income level
5. Max 401k (if 401k fees are lower than available in an IRA, swap #4 and #5)
6. Fund mega backdoor Roth if applicable
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.
8. Invest in a taxable account with any extra.

WHY
0. Give yourself at least enough buffer to avoid worries about bouncing checks
1. Company match rates are likely the highest percent return you can get on your money
2. When the guaranteed return is this high, take it.
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.
4. Rule of thumb: trad if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between
5. See #4 for choice of traditional or Roth for 401k
6. Applicability depends on the rules for the specific 401k
7. Again, take the risk-free return if high enough
8. Because earnings, even if taxed, are beneficial

seattlecyclone

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Re: Low interest student loans or invest in taxable account?
« Reply #4 on: April 24, 2016, 12:23:55 PM »
The amount in question isn't huge. You could pay them off completely in a few months if you wanted to. There's no wrong answer here. There's just a good option and a better option. Being able to deduct the student loan interest reduces the effective interest rate by a factor of your tax bracket, which nudges the math more in the direction of having investing be the better answer.

I'd say go for investing unless being debt-free would feel like a major weight off your shoulders. Paying off the loan is the sub-optimal decision from a probabilistic perspective, but it's not that much worse that it should necessarily override a strong emotional aversion to debt.

MDM

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Re: Low interest student loans or invest in taxable account?
« Reply #5 on: April 24, 2016, 03:22:56 PM »
Do you have enough deductibles to actually deduct the student loan interest?  If you take the standard deduction, that wouldn't be a consideration for keeping them (but, I've had Schedule A deductions since I was 19, not sure you can take them without that, and other factors that go with it--house, dependent, etc.)
Good question for the Schedule A deductions (e.g., mortgage interest, etc.).

Student Loan interest actually has its own line on the front of form 1040.  There is an income-based phaseout of this deduction, but if the OP contributes the planned $18K to a 401k from gross wages of $77K, the full SL interest deduction can be taken.

That reduces OP's effective interest rate to 75% of the nominal SL rates, making it (as seattlecyclone notes) that much more likely investing will be better.