Pay off student loan, interest free loan, or invest?

[Spondulix]

Right now I've got an extra $1000 cash a month to throw at something. Here are the options I'm considering:

• Student loans - 21k total (1 loan is 12k, the other is 9k). Both are 1.75% interest (fixed)
  
• Union fees - I owe $3000 for joining a union with my job. They are taking $200/month from my paycheck, but it's basically it's a 0% loan.
• Invest more in index funds - I've got a brokerage account with about 11k. 8k is Vanguard index, and $3k in stocks.
  

Other info:
I'm 34, spouse is 37, no kids yet.
Combined salary of around $125k
Credit cards paid off every month, no car loans. Our spending is low, but always room for improvements.
I've already maxed out our Roth IRAs for the year, and hubby is making SEP IRA contributions separately.
We each have 30-40k in retirement (behind where we'd like to be)
$10k in cash emergency fund
We have mortgage debt (around $280k left), but have probably $250k equity in the house and a low interest rate (3.8%).

I've read a lot of discussions about not paying off low interest loans (especially tax deductible, like student loans). It makes sense, but I also think I'm not giving myself the chance to compound the money I'm paying them long term.

I was making extra principal payments on the mortgage, but I think that's too much in one basket (especially living in an earthquake region). I've looked at calculators to compare paying off the student loans or investing - unless there's a stellar market for the next 5 years (which I don't see happening), there's not really a clear advantage to one over the other.

Any thoughts?

[Catbert]

I'd probably invest in index funds.  If your job is secure then there is no reason to be in a big rush to pay-off such low interest loans.

[retired?]

Is the school loan rate fixed?

I'd probably build up the emergency reserve and invest.  I agree with the idea of not paying down low interest rate loans, but you do get some peace of mind being debt-free.  If the rate is fixed, it would be hard to throw money towards the student loan.

I am not sure about the earthquake comment.  You've bought the house.  I know people often think "I only have X in this house", but unless you are willing to default in some circumstance, you are in it for the full purchase price.

[Cheddar Stacker]

Do you have 401k's? You mentioned a SEP IRA (so self employed) and a union (so likely a pension of some sort) but do you also have any 401k, 403b, 457 options available. That will be a good place to put some extra funds if you have any of that.

Also, if you have a SEP IRA, you might also look into an individual (solo) 401k as a different option that might allow for more annual contributions.

In any case, I vote invest in index funds, whether it be in a taxable account or any other account I just mentioned.

[Dicey]

First, thanks for being so smart about paying off low-interest loans early. Very advanced thinking for a mustachian forum newb. Did I really just thank you for being smart? Hell yes I did! We need more people who understand the difference between wealth building and wantonly killing debt. I know tone is sometimes hard to convey, but there is not a whit of condescension intended or implied, I assure you.

I'd be inclined to beef up the EF, as less than one month's net pay seems a little tight. If that doesn't blow your hair back, I'd look into Cheddar Stacker's wise suggestions.

[Rebecca Stapler]

At 1.75% interest, I can see why you would consider investing instead. But the benefit of paying off debt is that it makes you more financially independent sooner -- you need less money per month to "make ends meet." After you pay off those loans, you will have even more "extra" cash to invest. In fact, if you take your $11k brokerage account and your first month's $1,000, you could kill a loan -- and a payment -- tomorrow. Then you would have about $1,100/mo to invest, right? It's a beautiful thing ;)

Also, at $125k/year, you are at the threshold of having the SL interest deduction phased out. (http://www.irs.gov/publications/p970/ch04.html#en_US_2013_publink1000178283) So, your tax advantages diminish as your income increases.

I am curious why you have $11k in a taxable account but haven't contributed it to your retirement accounts. Have you maxed your annual IRA contribution this year already?

[Cheddar Stacker]

At 1.75% interest, I can see why you would consider investing instead. But the benefit of paying off debt is that it makes you more financially independent sooner -- you need less money per month to "make ends meet." After you pay off those loans, you will have even more "extra" cash to invest. In fact, if you take your $11k brokerage account and your first month's $1,000, you could kill a loan -- and a payment -- tomorrow. Then you would have about $1,100/mo to invest, right? It's a beautiful thing ;)

Also, at $125k/year, you are at the threshold of having the SL interest deduction phased out. (http://www.irs.gov/publications/p970/ch04.html#en_US_2013_publink1000178283) So, your tax advantages diminish as your income increases.

I am curious why you have $11k in a taxable account but haven't contributed it to your retirement accounts. Have you maxed your annual IRA contribution this year already?

There is no wrong answer here. Saving and either paying off debts or investing is the right thing to do. That said, sorry rebecca but I disagree with most of what you said here. Statistically/mathematically paying off low interest debts is likely a much slower path to FI.

You are correct the SL interest begins to phase out at $125K, but any 401k or IRA contributions should help keep them under the limit. 

[Spondulix]

Is the school loan rate fixed?

I'd probably build up the emergency reserve and invest.  I agree with the idea of not paying down low interest rate loans, but you do get some peace of mind being debt-free.  If the rate is fixed, it would be hard to throw money towards the student loan.

I am not sure about the earthquake comment.  You've bought the house.  I know people often think "I only have X in this house", but unless you are willing to default in some circumstance, you are in it for the full purchase price.

Thanks for your input - the loans are fixed rate. Why the emergency fund? I don't really understand why emergency funds need to be exclusively in savings. Last year, I was out of work for months and I still barely tapped into my $10k reserve (we adjusted by cutting back on spending a lot). I can't think of a realistic circumstance where I would need more than $10k immediately - where I couldn't use a credit card and later withdraw from my funds. So I'd love to know what I'm not seeing :)

I view living in an earthquake zone like living in a flood zone, or a forest prone to fires. It's bound to happen, so it's just a question of the damage. I have earthquake insurance, but the deductible is 20% - meaning in serious damage, I'd have to pay at least 80k out of pocket before anything is covered. I'd like to have that in emergency/funds vs having to take a second loan on the house. Worst case scenario, if my house was heavily damaged and I had to walk away from it, I'd want some equity outside the house. But you're saying that it doesn't matter cause I'd still be on the hook for the loan, right?

[Spondulix]

At 1.75% interest, I can see why you would consider investing instead. But the benefit of paying off debt is that it makes you more financially independent sooner -- you need less money per month to "make ends meet." After you pay off those loans, you will have even more "extra" cash to invest. In fact, if you take your $11k brokerage account and your first month's $1,000, you could kill a loan -- and a payment -- tomorrow. Then you would have about $1,100/mo to invest, right? It's a beautiful thing ;)

Also, at $125k/year, you are at the threshold of having the SL interest deduction phased out. (http://www.irs.gov/publications/p970/ch04.html#en_US_2013_publink1000178283) So, your tax advantages diminish as your income increases.

I am curious why you have $11k in a taxable account but haven't contributed it to your retirement accounts. Have you maxed your annual IRA contribution this year already?

The SL deduction I've been getting isn't doing much for me, so it's not a huge concern (it's under $500/year, vs over $6k for my mortgage deduction. A calculator just said my SL interest will be $1200 over the life of the rest of the loan) But I didn't know it gets phased out, so thanks for mentioning!

I totally see the power of getting the debt off the books, but I am concerned about having cash (or something to convert to cash) available if I have an unforeseen emergency. One thing I've considered is building up to a goal amount, say $20k, then pay one loan in full (that would probably be next year). Then, the following year, do the same thing and pay off the other.

As for IRA/401k - my work 401k kicks in next month (it had a six month wait). My employer automatically pays 3%, so I was thinking of doing 7% contributions (the 1k I'm talking about will be on top of that). The SEP IRA is from past years of being self-employed, but I have little income there anymore (so my max contribution would be pretty small - is it still worth it?). My husband funds his SEP IRA from his business, and I'm encouraging him to put as much as he can to make up. As for having 401k in addition... That's something I know very little about! So I'm all ears.

[Spondulix]

First, thanks for being so smart about paying off low-interest loans early. Very advanced thinking for a mustachian forum newb. Did I really just thank you for being smart? Hell yes I did! We need more people who understand the difference between wealth building and wantonly killing debt. I know tone is sometimes hard to convey, but there is not a whit of condescension intended or implied, I assure you.

I'd be inclined to beef up the EF, as less than one month's net pay seems a little tight. If that doesn't blow your hair back, I'd look into Cheddar Stacker's wise suggestions.

Thanks Diane! I take that as a huge compliment. :) Everyone's advice is great - it's exactly what I needed. I've been lurking the forum a while, but I made the shift about a year ago from thinking about getting out of debt to wealth building. It was psychology books (about relationship with money) versus finance education that really made it click. MMM has been a great resource, too.

I just mentioned in another response, but I'm interested to know why you all think its important to have more emergency fund in cash/savings (vs convertible funds, like stocks or bonds).

[Dicey]

Because stocks and bonds can rise and fall in value. You never want to have an emergency when they are down or your pain is doubled. I tend to keep a large cash EF (not a popular position here, but it works for me) earning virtually nothing these days. To compensate for this, I keep minimal cash (1-2%) in my investment portfolio.

[pagoconcheques]

As for IRA/401k - my work 401k kicks in next month (it had a six month wait). My employer automatically pays 3%, so I was thinking of doing 7% contributions (the 1k I'm talking about will be on top of that).
[/quote]

Since you've just become eligible for the employer match I'll assume you had no contributions to the 401(k) earlier n the year.  I believe, and hopefully someone in the know can chime in, that you can contribute up to the annual maximum (17k if memory serves) even if you are not employed for the whole year.  Sure, the employer will only pay the match going forward from your eligibility date, but you can still upfund your new 401(k) to maximize that tax-advantaged savings for these few thousand dollars from now until retirement.  Once 2015 starts, change your contribution amount to spread it out evenly over the year and revisit your question about saving for the EF or paying off the low interest SLs. 

I'm posing this as a possibility since I'm not sure--curious to see what others say.

[retired?]

I view living in an earthquake zone like living in a flood zone, or a forest prone to fires. It's bound to happen, so it's just a question of the damage. I have earthquake insurance, but the deductible is 20% - meaning in serious damage, I'd have to pay at least 80k out of pocket before anything is covered. I'd like to have that in emergency/funds vs having to take a second loan on the house. Worst case scenario, if my house was heavily damaged and I had to walk away from it, I'd want some equity outside the house. But you're saying that it doesn't matter cause I'd still be on the hook for the loan, right?

I see what you mean.  With emergency fund, in my view, it can be in anything liquid that doesn't have too much risk associated with it.  Sure, credit cards can be used.  MMM recommends using a HELOC.  I had one with previous house and the rate was Prime + 0.25....around 4.25 at the time. 

yes, on the hook for the loan.  I thought you meant too much of your wealth allocation in your main home.  Walking away after major damage may be treated differently than walking away from a loan b/c the house has lost a lot of value (referred to as strategic default).  Not sure, though.

[waltworks]

Answer to original question: index funds.

Now:

At $125k income and DINK, why are you only throwing $1k a month at debt/investing? Are you really spending ALL of the rest somehow? Seriously? Facepunch time: unless you fix your spending, you are on track to have zero chance at FIRE.

Post a case study. Given the info you've already given us I am having a hard time wrapping my brain around only saving ~10% of your income even if you're *not trying* to save money.

-W

[Cheddar Stacker]

Answer to original question: index funds.

Now:

At $125k income and DINK, why are you only throwing $1k a month at debt/investing? Are you really spending ALL of the rest somehow? Seriously? Facepunch time: unless you fix your spending, you are on track to have zero chance at FIRE.

Post a case study. Given the info you've already given us I am having a hard time wrapping my brain around only saving ~10% of your income even if you're *not trying* to save money.

-W

@walt, if you look a little closer at the opening post you'll see they've already maxed out their Roth's + are making contributions to Husbands' SEP. They're saving more than you think. Also, they own a $500K+ house, likely in California, so I'm sure the mortgage payment is a huge % of their net pay.

@pagoconcheques, good point if they can afford it. Might be tough to put away the full 17,500 limit in her 401k in 3 months when they only have an extra $1,000/month, but they should put as much as possible into that to avoid the 25% tax bracket.

@Diane C, I think your plan is solid for you since you're retired. I don't like it as much for act01 as I think $10K is plenty and they have a huge amount of home equity to lean into if need be. I'd keep the EF at $10K.

@act01, it won't matter if you do your SEP IRA or your newly minted 401K. With only 3 months left you wouldn't be able to max the 401k so keep it simple and just put whatever you can into that. For your husband I mentioned looking into a solo 401k but I'm fairly certain that can't be done in addition to his SEP IRA. The good thing is, the solo 401k gives you plenty of flexibility so you shouldn't need both - see quote below. Here's a link that summarizes each type of self employed plan: http://www.irs.gov/Retirement-Plans/Retirement-Plans-for-Self-Employed-People

401(k) Plan
•Make salary deferrals up to $17,500 in 2013 and 2014 (plus an additional $5,500 if you're 50 or older) of your compensation from the business either on a pre-tax basis or as a designated Roth contribution.
•Contribute up to an additional 25% of your net earnings from self-employment (not including contributions for yourself), up to $51,000 for 2013 ($52,000 for 2014) including salary deferrals.
•Tailor your plan to allow access to your account balance through loans and hardship distributions.

A one-participant 401(k) plan is sometimes referred to as a “solo-401(k),” “individual 401(k)” or “uni-401(k).” It is generally the same as other 401(k) plans, but because there are no employees other than your spouse who work for the business, it is exempt from discrimination testing.

[waltworks]

No, something still doesn't add up. Even with a pricey house they're not paying more than $2.5/mo or so in mortgage payments at that rate. The IRAs are only $5500 each/year. SEP isn't even fully funded? There is a ton of money going missing if there is $10k gross per month to work with and no debts outside of mortgage.

-W

@walt, if you look a little closer at the opening post you'll see they've already maxed out their Roth's + are making contributions to Husbands' SEP. They're saving more than you think. Also, they own a $500K+ house, likely in California, so I'm sure the mortgage payment is a huge % of their net pay.

[Cheddar Stacker]

Maybe. I was guessing 2,500 for mortgage as well. I'd also guess ~1,500-2K/month in taxes since they are likely in CA with a high state rate. Add in SL debt payments, retirement funding, building up that $10K EF and it takes up a lot of space. Also, she just got a new job and might have taken a nice pay increase so this $125K might be new. Maybe they've just discovered this website and haven't implemented too many things. Maybe the $125K includes the gross SE income and there are business expenses not mentioned. Could be many things.

But I agree, @act01 if you're looking for a lot more feedback on how to save more, a case study is always a way to get a lot of eyes giving you good advice. Although be prepared because most people don't hold back and will skewer you for spending money on just about anything they don't.

[Spondulix]

Maybe. I was guessing 2,500 for mortgage as well. I'd also guess ~1,500-2K/month in taxes since they are likely in CA with a high state rate. Add in SL debt payments, retirement funding, building up that $10K EF and it takes up a lot of space. Also, she just got a new job and might have taken a nice pay increase so this $125K might be new. Maybe they've just discovered this website and haven't implemented too many things. Maybe the $125K includes the gross SE income and there are business expenses not mentioned. Could be many things.

But I agree, @act01 if you're looking for a lot more feedback on how to save more, a case study is always a way to get a lot of eyes giving you good advice. Although be prepared because most people don't hold back and will skewer you for spending money on just about anything they don't.

@waltworks You're right that the numbers don't add up (especially if you factor in that my monthly mortgage is $1475, taxes around $700/month). @cheddar stacker nailed it on the head that I got a huge pay bump (over 30%) and went from freelance to employee (which lowered my expenses even more). My husband's business is having a good year, so we will probably end up above $125k. I'm definitely still getting oriented to the new financial situation.

Where the extra money is - first, I paid off a car loan (about 10k over 3-4 months), then maxed out remaining for Roth IRAs. I need to save a couple grand a month for upcoming property tax bills (4k in Nov, 4k in Feb) and then we need some home repairs (10k or more). But after that, I'm not totally sure.

Given it was my first post, I was a bit hesitant to throw out everything as a case study. If I were to do that, should I update this post or is it better to do start a new one? Thank you again for all your advice!

[Spondulix]

Since you've just become eligible for the employer match I'll assume you had no contributions to the 401(k) earlier n the year.  I believe, and hopefully someone in the know can chime in, that you can contribute up to the annual maximum (17k if memory serves) even if you are not employed for the whole year.  Sure, the employer will only pay the match going forward from your eligibility date, but you can still upfund your new 401(k) to maximize that tax-advantaged savings for these few thousand dollars from now until retirement.  Once 2015 starts, change your contribution amount to spread it out evenly over the year and revisit your question about saving for the EF or paying off the low interest SLs. 

Correct, I've had no other 401k contributions this year. I will definitely look into upfunding (this option makes a lot of sense to me, given I want to make up some retirement funds for years I didn't contribute.)

[Cheddar Stacker]

If you choose to do so, read the "how to post a case study" thread, then post a new thread and link to it over here so we can all check it out.

[waltworks]

That makes more sense. If you're unsure of where to go with the new financial situation and *want* feedback, a case study will give you lots of great ideas (just writing it up may be helpful, even if you decide not to post it in public).

Kudos on the great year. Keep it rolling!

-W

[Gin1984]

At 1.75% interest, I can see why you would consider investing instead. But the benefit of paying off debt is that it makes you more financially independent sooner -- you need less money per month to "make ends meet." After you pay off those loans, you will have even more "extra" cash to invest. In fact, if you take your $11k brokerage account and your first month's $1,000, you could kill a loan -- and a payment -- tomorrow. Then you would have about $1,100/mo to invest, right? It's a beautiful thing ;)

Also, at $125k/year, you are at the threshold of having the SL interest deduction phased out. (http://www.irs.gov/publications/p970/ch04.html#en_US_2013_publink1000178283) So, your tax advantages diminish as your income increases.

I am curious why you have $11k in a taxable account but haven't contributed it to your retirement accounts. Have you maxed your annual IRA contribution this year already?

The SL deduction I've been getting isn't doing much for me, so it's not a huge concern (it's under $500/year, vs over $6k for my mortgage deduction. A calculator just said my SL interest will be $1200 over the life of the rest of the loan) But I didn't know it gets phased out, so thanks for mentioning!

I totally see the power of getting the debt off the books, but I am concerned about having cash (or something to convert to cash) available if I have an unforeseen emergency. One thing I've considered is building up to a goal amount, say $20k, then pay one loan in full (that would probably be next year). Then, the following year, do the same thing and pay off the other.

As for IRA/401k - my work 401k kicks in next month (it had a six month wait). My employer automatically pays 3%, so I was thinking of doing 7% contributions (the 1k I'm talking about will be on top of that). The SEP IRA is from past years of being self-employed, but I have little income there anymore (so my max contribution would be pretty small - is it still worth it?). My husband funds his SEP IRA from his business, and I'm encouraging him to put as much as he can to make up. As for having 401k in addition... That's something I know very little about! So I'm all ears.

I'd use the money to max out your 401k not just put 7% in.

[Spondulix]

Update... I have a plan! Putting together a case study was indispensable - so thanks guys for recommending that. It turns out I was eligible to start my 401k anytime (doh!), so I setup today and decided to do 25% contribution through the end of the year. Having all the numbers made it easy to figure out (and to be confident about it - my original 1k estimate was really a conservative shot in the dark).

Next year I'll spread it evenly (which is also easy to calculate w/ the numbers). I found some places I can rope in my spending too, which is awesome. Just need to get the hubby on board, and get his tech addiction under control :)

Thanks again to everyone for the input - I think I got more out this thread than I have in the past 5 years with my accountant...