The Money Mustache Community
Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: TSMonk on July 01, 2016, 09:47:44 AM
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Hello,
I've seen a lot of advice that says to pay down non deductible debt first with not a lot of reasoning behind it. What if for example, the rate on that debt is low and I would expect a higher return in the market? For example, I have a car loan at 2.29% with a term of 5 years. Assuming I have achieved the maximum possible 401k match for my employer and I have maxed contributions to an IRA, why should I pay this down first before non-tax advantaged investing? Just curious if there was some logic that I am missing.
Thanks!
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No, I wouldn't apply a blanket rule of "pay off non-deductible debt first." Instead, pay off debts starting with the highest interest rate first, taking into account any tax deductions that may apply. For example, if you're in the 25% tax bracket and you have student loans with fully deductible 5% interest, your effective interest rate is actually 3.75% (75% of 5%). Compare that effective rate to your other loans to see which ones you should prioritize.
Also there's some rate below which it makes sense to invest in the market instead of paying off the debt faster than required. Where that line is depends on your personal risk tolerance and aversion to debt; 5% is a common rule of thumb. Pick a number that makes sense for you, aggressively pay off debt higher than that rate, and then switch to increasing your savings when you only have loans with a lower rate remaining.
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cant argue with that sound math logic right there ^^^
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No, I wouldn't apply a blanket rule of "pay off non-deductible debt first." Instead, pay off debts starting with the highest interest rate first, taking into account any tax deductions that may apply. For example, if you're in the 25% tax bracket and you have student loans with fully deductible 5% interest, your effective interest rate is actually 3.75% (75% of 5%). Compare that effective rate to your other loans to see which ones you should prioritize.
Also there's some rate below which it makes sense to invest in the market instead of paying off the debt faster than required. Where that line is depends on your personal risk tolerance and aversion to debt; 5% is a common rule of thumb. Pick a number that makes sense for you, aggressively pay off debt higher than that rate, and then switch to increasing your savings when you only have loans with a lower rate remaining.
So much this. I've seen way too many people who are otherwise good at math (and even finances!) get huge blinders on when they think about 'tax deductions'.
Your tax deduction doesn't suddenly make things 'free'.
(Not saying the OP thinks this way, but just a tangential rant related to the topic that I bottle up, haha).
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Don't forget that it's really only a deduction for the amount that is over the standard deduction.
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Don't forget that it's really only a deduction for the amount that is over the standard deduction.
+1
It also depends on what your monthly cushion is and if you have a decent emergency fund. If things are really tight, paying off the smaller balances will remove those payments from your budget and give you some wiggle room.
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Don't forget that it's really only a deduction for the amount that is over the standard deduction.
That really depends on what type of debt it is. For mortgages on your primary residence, sure. The standard deduction certainly comes into play with those. If it's a student loan or a business loan or a mortgage on a rental property, you may be able to deduct the whole amount independent of the standard deduction.
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Ok. How about paying off debts before investing? For low rate debts, would you recommend taking extra cash monthly as prepaying these loans or investing it given that you can reasonably expect a higher rate of return.
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The math favors investing over paying off loans when the expected return on your investment is greater than the loan's interest rate.
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Op, I would max the 401k before paying off the loans or looking at after tax investing.