New Mustachian with a windfall- murder loans or first investment?

[singingbiologist]

Hi Mustachians,

Long time reader, first time poster here- nice to meet all of you!

I'm a 29 year old grad student set to finish my phd in 2016, with a nice government job on the other side. My husband is a butcher, freelance writer, and grad student caretaker. Together we pull in around 55k per year, and are busily paying down about 30k (remaining) school loans, most of which are deferred but accruing interest. We have about 10k in checking and savings accounts, and are actively working to slash our ballooned spending (about 3.5k/month, including 1k towards those pesky loans). No debt other than student loans, so that's a plus.

We recently had some good luck and are getting cut a check for about 10k - a one time windfall. Generally all our extra cash goes to paying down debt, but this seems like a good opportunity to start a Vanguard or something to that effect.

Any advice for us kids just starting out in the road to Mustachianism? What would you do with your first extra 10k?

[ltt]

Personally, I would slash the debt.  I know a lot of people will say that student loan debt is good debt; but it's simply just more debt.

[waltworks]

Unless the debt is at some crazy low rate, I would just kill debt, as boring as it sounds.

-W

[Zamboni]

Why not do a little of both?  Find out what you need to get the account open at Vanguard (varies by type of account.)  Commit that there, then put the rest to the debt.  Two birds, one stone.  And then maybe celebrate by getting yourself a chocolate croissant or something.

PS once the account is set up you can go online and link it for automatic monthly smaller contributions every time you get paid.

[NoraLenderbee]

Use some of it to start a retirement account--an IRA or Roth IRA. Put in whatever the minimum is that Vanguard requires to invest in something basic, like the total market index. Even if it isn't much to start, it will grow over time, and it's very motivating to have that money working for you. (If you already have retirement accounts, add more to them, or start a brokerage account.)

Then have the chocolate croissants, and a nice beer, and apply the rest to the debt.

[TerriM]

What's the interest rate on your loans?  Seems like the answer should depend highly on that.


Personally, I'm a fan of killing debt even if an investment would make more money.  Student loans are the one debt that will not go away even in bankruptcy.  Might as well get rid of it now rather than let it linger.  There's an emotional toll that debt takes, and a happy feeling of self-control that being out of debt gives you.  The only exception for me would be trying to buy a house in a RE downturn--if it were 2009/2010 again, I'd say buy the house, pay the loans off later.

[Self-employed-swami]

The 'mathematically correct' answer is to pay the debt if the interest rate is higher than reasonably expected returns on an investment.  You also need to take into account the effective interest rate on the loans, which is the posted rate, minus whatever tax benefit you get from paying the interest.

But, from a more practical side, I might be inclined to use half to pay the highest interest loan, and invest the other half, so you have a bit of an emergency fund, if needed.  Again though, this is dependant on the interest rate on your loan, and assuming that it is somewhere close to 4-6%.  If you enough loan at something above 8%, I'd pay off as much as possible.

How's that for a non-answer?
;)

[wwweb]

If the interest rate on the loans is above 5%, I'd put every cent into paying down the loans.  If it's below 3%, I'd max out a Roth IRA or other tax advantaged account.  In the 3%-5% range, I'd probably split the money between a tax advantaged account and the loan.

The interest rate on the loan is key.

[singingbiologist]

Thanks, Mustache Army. Its nice to get some outside perspective on this sort of thing. Since the husband and I are new at the whole investing game, it's hard to know what makes sense.

If it helps, the loan breakdown:
2.5k at 6.8% (active - we've been paying this off at about a 1k per month)
10.6k at 6.8% (deferred, accruing interest that we are paying down)
6k at 1.79% (deferred, accruing interest)
8.5k at 6.8% (deffered, not accruing any interest, so this is our lowest priority loan)

Thanks again!

[nereo]

Thanks, Mustache Army. Its nice to get some outside perspective on this sort of thing. Since the husband and I are new at the whole investing game, it's hard to know what makes sense.

If it helps, the loan breakdown:
2.5k at 6.8% (active - we've been paying this off at about a 1k per month)
10.6k at 6.8% (deferred, accruing interest that we are paying down)
6k at 1.79% (deferred, accruing interest)
8.5k at 6.8% (deffered, not accruing any interest, so this is our lowest priority loan)

Thanks again!

my personal opinion:  Don't pay off the 6k at 1.79% or the subsidized 8.5k loan (right now).  I'd happily kill the 2.5k loan and most of the 10.6k loan.  But taking $1k of your windfall and opening up a Vanguard IRA isn't a bad idea either since you will get a tax break in April and you'll have some savings which will start to compound and could be tapped in a last-ditch emergency situation.

[geek101]

With those loan rates, I would use it to kill the debt. With this 10K and then the 1K a month you are already doing, you will be able to kill all of the high interest loans quickly. Then you can start investing.

The biggest thing is to recognize if you are suffering from any irrational psychology that could be clouding your judgement, for instance 'mental accounting' http://www.investopedia.com/university/behavioral_finance/behavioral5.asp

The short version is that money is money. If this money came from a different source (say you just took home 10k more than you actually do), what would you use it for? That answer shouldn't be any different than your answer for the 10k as a windfall. Money is money, it doesn't matter where it comes from.

Consider these questions: If you found a crisp $10 bill on the street, what would you do with it? What about $100? $1000? The answer to all these questions should be the same as your 10k answer. Since you effectively said 'we usually use all our extra money to pay down debt' this money shouldn't be used any differently.

Now, whether you decide to kill debt, invest, or a combination of the two, as long as that is the answer for all of these scenarios, you are fine, and that decision can be made off a number of factors. You can do the maximization strategy of getting the most out of every dollar, you may decide you want to be debt free and that's more important than the mathematically best option (investing after the 6% and higher loans are gone), it's your decision. Just make sure you don't have any of the irrational biases in that article affecting your decision.

[nereo]

The biggest thing is to recognize if you are suffering from any irrational psychology that could be clouding your judgement, for instance 'mental accounting' http://www.investopedia.com/university/behavioral_finance/behavioral5.asp

Thanks for that link - very interesting.  It seems very similar to the concept of how money is fungible.

[TerriM]

With those loan rates, I would use it to kill the debt. With this 10K and then the 1K a month you are already doing, you will be able to kill all of the high interest loans quickly. Then you can start investing.

Seconded.  Even the $8.5K interest deferred loan will come due soon enough.  Better to kill it off before the monster grows.  And with $10K in your checking account, you have a good safety fund already.  Also, if you'll get paid a lot better in the future, wouldn't it be better to wait for the Vanguard  tax-deduction when you're in a higher tax bracket?

[nereo]

Also, if you'll get paid a lot better in the future, wouldn't it be better to wait for the Vanguard  tax-deduction when you're in a higher tax bracket?

No - because you can only contribute $5500 per tax year.  If he contributes now he gets the tax break for 2014, and then he still is eligible for up to $5500 in subsequent years.  Presumably with $1k/month aimed at the loans currently he'll be able to fully contribute every year from 2015 onward as his loans disappear and his monthly cashflow opens up.
I don't agree that he should pay off a loan currently at 0% and 1.79%, but I agree with your other recommendations.

[DecD]

I'd kill the 2.5K loan and then put the rest on the 10.5K loan.  You'll be through with that one as well in no time!  And it'll feel great.

[klystomane]

Use some of it to start a retirement account--an IRA or Roth IRA. Put in whatever the minimum is that Vanguard requires to invest in something basic, like the total market index. Even if it isn't much to start, it will grow over time, and it's very motivating to have that money working for you. (If you already have retirement accounts, add more to them, or start a brokerage account.)

Then have the chocolate croissants, and a nice beer, and apply the rest to the debt.

+1

If you don't have an investment account, I would start it for motivational reasons. Put in the minimum, and just look at it from time to time to remind yourself.

Set aside enough for a short-term emergency, and apply the rest to the loan.

It might look like this:
1. Vanguard: 3k
2. Checking/Savings: 1k
3. Loans: 16k

You will then have 14k remaining in your loan. If you two are pulling in 55k a year, can you feasibly throw 2k+ per month towards the loan? You could feasibly be debt free within 7 months.

It's only going to suck for 7 months...which in the grand scheme of things is nothing.

[TerriM]

Also, if you'll get paid a lot better in the future, wouldn't it be better to wait for the Vanguard  tax-deduction when you're in a higher tax bracket?

No - because you can only contribute $5500 per tax year.  If he contributes now he gets the tax break for 2014, and then he still is eligible for up to $5500 in subsequent years.  Presumably with $1k/month aimed at the loans currently he'll be able to fully contribute every year from 2015 onward as his loans disappear and his monthly cashflow opens up.
I don't agree that he should pay off a loan currently at 0% and 1.79%, but I agree with your other recommendations.

Ahh ok.  Good point. 

I'm not too worried about the 1.79% loan either, but I'm assuming that the 0% loan will start accruing interest and require payment on graduation which sounds like 18 months from now.   It would be great to have that one paid off before that starts happening.

[skunkfunk]

With those loan rates, I would use it to kill the debt. With this 10K and then the 1K a month you are already doing, you will be able to kill all of the high interest loans quickly. Then you can start investing.

Seconded.  Even the $8.5K interest deferred loan will come due soon enough.  Better to kill it off before the monster grows.  And with $10K in your checking account, you have a good safety fund already.  Also, if you'll get paid a lot better in the future, wouldn't it be better to wait for the Vanguard  tax-deduction when you're in a higher tax bracket?

Agreed.

The only thing that I would add is that there are only a few months left to max out a 2014 Roth IRA, which is a great investment / emergency fund vehicle.

[nereo]

I'm not too worried about the 1.79% loan either, but I'm assuming that the 0% loan will start accruing interest and require payment on graduation which sounds like 18 months from now.   It would be great to have that one paid off before that starts happening.

Paying off the 0% loan wouldn't be a "bad" thing per se, but it's currently at 0% interest.  Which means that inflation is eating away at it every year.  If the OP has 18 months until graduation, the loan won't enter repayment for 2 years.  On his current track it and the 1.79% loan will be the only remaining loans at the end of next year.  My advice was simply to let inflation nibble away at it while increasing his 'stache.  When the time comes he can kill it very quickly.
maximum benefit, maximum 'stache.  Let the math work for you :-)

[singingbiologist]

You guys are all awesome. Thanks so much for helping me think through this rationally! I'll talk things through with the husband, and report back on the final decision.

Hooray for good beer and good croissants, by the way :)

(And good financial decisions, too!)

[trout14]

Kill the debt. A RothIRA is max $5500 per year, but is not tax deductable, (after tax) and can be contributed to until April 15th of 2015, for the 2014 year if for some reason you wanted to. Going with math is not always the best, don't discount how good it feels to pay off a 1/3 of your debt at one time.

[GreenPen]

I'll cautiously disagree with most of the posters so far on this thread: I don't think you should pay off any loans right now (even those at 6.8%). Instead, I would recommend investing all of this money in an IRA or Roth-IRA and waiting until 2016 to pay off your loans.

It seems relevant that your income will substantially increase after you finish your PhD in a little over a year. If you have that nice job waiting for you, it should be relatively easy to max out all of your retirement accounts AND pay off all of these loans in either 2016 or 2017 (depending on when you start your job). If you pay off the loans now, then you are paying them off with income that is missing out on preferable tax treatment. But if you pay off the loan in 2016 (after maxing out all tax-advantaged accounts), then the income that you use to pay off the loan wouldn't be missing out on preferable tax treatment.

Am I crazy for thinking this? It's quite possible (and maybe even likely) that I am missing something obvious. I would be interested in hearing from others if my suggestion is crazy -- especially since I'm in a similar position as the original poster.

[nereo]

Kill the debt. A RothIRA is max $5500 per year, but is not tax deductable, (after tax) and can be contributed to until April 15th of 2015, for the 2014 year if for some reason you wanted to. Going with math is not always the best, don't discount how good it feels to pay off a 1/3 of your debt at one time.
(emphasis added)

I must say I've never really understood the sentiment about how it will feel "good" when a loan is gone.  One of my biggest financial regrets was bending to family pressure and using savings to pay off a SL at 2.2% (which would have subsequently gone back into subsidized deferment for another 4 years).  Every time I think about it I just think "man, what a waste!"  Not only did my 'stache shrink, but lost several years of deducting SL interests, and i missed the chance for interest to nibble away at the loan.

which I guess brings us to  the investment command of "know thyself."  If you will get joy from paying off those loans early, than do so.  If you're likely to miss what you lost, go with the math.  everyone reacts differently.

[geek101]

RedPen: It's the age old invest vs. pay of debt question. Your suggestion isn't crazy, but here are some points to consider. On the tax treatment issue, pretax contributions are going to be more effective at a higher income, so every dollar spent on debt now is a dollar that doesn't have to be spent on debt later, and  can be invested in a 401k/tIRA in the future. Additionally, always expecting your income to increase is a dangerous assumption. What happens if it takes the OP a year or longer to put that PhD to use? "We can afford it later" can get you in trouble. I'm pretty sure "we can afford it later" is a common justification for the millions of people living above their means. Work with the numbers you have now and do the best with what you've got. When something significant changes you can always reevaluate in the future.

nereo: In this case the math argues heavily for paying off debt. We're no talking about 2.2% as in your case, we're talking about 21.6k of 6.8% debt. If you're telling me you wouldn't put 21.6k in an investment guaranteed to return 6.8% with zero risk, you have some high expectations of your investments.

[nereo]

nereo: In this case the math argues heavily for paying off debt. We're no talking about 2.2% as in your case, we're talking about 21.6k of 6.8% debt. If you're telling me you wouldn't put 21.6k in an investment guaranteed to return 6.8% with zero risk, you have some high expectations of your investments.

My comment about not feeling good was specifically a response to trout14's comment.  Paying off loans when they are very low rates doesn't give my any satisfaction - in fact it does the opposite.
also, you have an error with your math.  the OP doesn't have 21.6k of SL debt at 6.8%.  He has 13.1k at 6.8%, with the rest at 1.79% or at 0% as sub.-def.  You'll notice that in my earlier post I followed a similar logic to you - that the OP should pay down the 6.8% portions now, but perhaps consider putting some money towards a tIRA to get the reduce his tax burden.  With a 10k windfall plus the ability to pay $1k/month in SL the OP has the ability to fully fund a tIRA for both 2014/2015 as well as eliminate all of his debt accruing at 6.8% before the April 15, 2015 deadline.  No, I would not pay down the other debt at their current rates.
hope that clears up my earlier posts for you.  Cheers!

[feelingroovy]

I'm pretty debt averse, so am usually in the "pay off debt first" camp, especially at those interest rates.  That's a guaranteed return.  Investments aren't.

But....

How much do you pay in income tax? At your income level (below $60k, Married filing jointly), you should qualify for the Saver's Tax credit, which could result in as much as a $2k tax credit (not deduction).  But you have to put money into retirement savings.

That's in addition to whatever tax savings you would already get from say, a traditional IRA.  The rules aren't straightforward  though--the credit is a % of the retirement savings phased out at different income levels, and I think you have to actually owe tax to get the credit.  So I would definitely check into the rules and do the math.

Maybe invest enough in IRAs to maximize tax savings, then put the rest toward the debt.

[horsepoor]

I'll cautiously disagree with most of the posters so far on this thread: I don't think you should pay off any loans right now (even those at 6.8%). Instead, I would recommend investing all of this money in an IRA or Roth-IRA and waiting until 2016 to pay off your loans.

It seems relevant that your income will substantially increase after you finish your PhD in a little over a year. If you have that nice job waiting for you, it should be relatively easy to max out all of your retirement accounts AND pay off all of these loans in either 2016 or 2017 (depending on when you start your job). If you pay off the loans now, then you are paying them off with income that is missing out on preferable tax treatment. But if you pay off the loan in 2016 (after maxing out all tax-advantaged accounts), then the income that you use to pay off the loan wouldn't be missing out on preferable tax treatment.

Am I crazy for thinking this? It's quite possible (and maybe even likely) that I am missing something obvious. I would be interested in hearing from others if my suggestion is crazy -- especially since I'm in a similar position as the original poster.

If the OP will be starting a federal job in the middle of 2016, it would be great if she was in the position to max her TSP account in the second half of the year.  This would really have a big effect on taxes since she'd only be at the higher earning level for half of the year, vs. ion 2017 when she'll be earning a full year's salary.  So having a couple of those student loan payments gone prior to starting work could be advantageous, depending on starting salary and expenses and so on.

[tracylayton]

I would pay off some of the higher interest debt.

[GreenPen]

I think I should rephrase my earlier comment. Here is why I think the OP should not pay down any of her debt this year:

If the OP invests the 10k in a tax-advantaged account, then she will likely save thousands of dollars in the future when she goes to withdraw this money. This should easily outweigh the cost of holding onto 10k in loans at 6.8% for an extra year or two until she finishes graduate school.

So I disagree with those who think that paying off the loans is the "mathematical" choice. It wouldn't be a terrible thing to take the guaranteed 6.8% (by paying off the loans). But doing so would come with an opportunity cost, and the OP would likely pay more money in taxes down the line than she would save by paying off the loan a year or two early. So it seems that the OP shouldn't pay off her loans at the expense of not maxing out her tax-advantaged accounts, even if that means not paying off the loans until 2016 or early 2017.

Singingbiologist: On a somewhat different note, in addition to the 10k windfall, it looks like that 10k in a savings/checking account is serving as your emergency fund. I would recommend opening a 2014 roth-IRA, and holding your emergency fund in that account. It is always possible to withdraw your contribution from a Roth account without penalty (in the event of an emergency, or early retirement). Just make sure you keep this money in CASH or something similar until you rebuild a normal emergency fund outside of this account.

[nereo]

I think I should rephrase my earlier comment. Here is why I think the OP should not pay down any of her debt this year:

If the OP invests the 10k in a tax-advantaged account, then she will likely save thousands of dollars in the future when she goes to withdraw this money. This should easily outweigh the cost of holding onto 10k in loans at 6.8% for an extra year or two until she finishes graduate school.

So I disagree with those who think that paying off the loans is the "mathematical" choice. It wouldn't be a terrible thing to take the guaranteed 6.8% (by paying off the loans). But doing so would come with an opportunity cost, and the OP would likely pay more money in taxes down the line than she would save by paying off the loan a year or two early. So it seems that the OP shouldn't pay off her loans at the expense of not maxing out her tax-advantaged accounts, even if that means not paying off the loans until 2016 or early 2017.

Since I'm the only one who used the word "mathematical" in any of the above posts I assume this comment is directed at me. 
I believe that we're saying essentially the same thing but not exactly understanding one another.  The OP has $13.1k debt at 6.8% and the ability to contribute $1k/month towards either debt or savings.  She also has 5 months to contribute to a 2014 tIRA (presumably both for her and her spouse).  So between now and next April the OP has ~$15k to put towards loans and/or tax advantaged accounts (a bit more if they continue cost-cutting measures) for 2014, plus an additional ~$12k before the end of the 2015 tax year.  Investing in a tIRA would yield a 20-25% savings this tax year (depending on deductions).  I am agreeing with you that she should put money towards tax advantaged accounts, and then also eliminate the $13.1k by the end of 2015.  Considering the tax savings (+~$2,200), both can be easily accomplished.  Her remaining subsidized loan won't enter repayment until c.2017, and there will be ample time to prepare for that after eliminating the the ones currently accruing interest by the end of next year.

[singingbiologist]

Thanks again, all. We decided to throw 8k at the 10.5k loan (take THAT, debt!), start up a Roth IRA with another 1k, and toss the other 1k into our savings account/emergency fund. We are planning to kill the last of the 2.5k loan in January, which will be an awesome start to 2015.

Have a frugal New Year, and thanks for your thoughts!