Author Topic: Pay Off Student Loan, or Start Investing?  (Read 3474 times)

Deimyts

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Pay Off Student Loan, or Start Investing?
« on: August 25, 2016, 10:48:57 AM »
My wife and I have been paying off my student loans like mad, and we're finally starting to see the light at the end of the tunnel. We've knocked out all of the higher interest loans, and we only have one left. It's fairly large, but the interest rate is low. Should we pay it off as fast as possible for greater security and the psychological win factor, or start paying the minimum, and investing the money instead?

Here's the details:

Loan Balance: $18,870.73
Interest Rate: 3.140% Variable
Monthly Payment: $132.97

Emergency Fund: $3,500
Other Debt: None. We have a credit card that we pay in full every month.

Until now, we've been putting about $3000 per month towards the loans. If we keep doing that, we could pay this one off by early next year.

With the current interest rate, I think that works out to about $600 per year in interest, getting smaller over time.

My current thought is this:
 1. Temporarily reduce loan payments, build up our emergency fund a little bit more, to somewhere between $6000-$10000.
 2. Split the previous $3000 monthly payment between the student loan and an investment (either our 401ks or a generic index fund). The split would probably be something like Loan: $1000/Savings: $2000.

However, I'm tempted by the possibility of paying off the loan as quickly as possible, especially since the interest rate is variable.

On the other hand, if we do start investing right now, should we max out our 401ks first, or go straight to a more liquid, but less tax-advantaged investment? We already both contribute enough to our 401ks to get the employer match. To complicate things even further, we also have HSAs that we could increase our contributions to.

What do you all think?

HotPotato

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Re: Pay Off Student Loan, or Start Investing?
« Reply #1 on: August 25, 2016, 10:53:06 AM »
I don't really have any advice on your personal situation but I decided the best bet was to throw every extra $ I had at my SL after graduation (5.5-7.5% interest) so it made the most sense for me. One thing to keep in mind is that your SL interest is tax deductible.

Deimyts

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Re: Pay Off Student Loan, or Start Investing?
« Reply #2 on: August 25, 2016, 10:59:14 AM »
One thing to keep in mind is that your SL interest is tax deductible.

That's true, but I've hit the maximum deduction for student loan interest ($2500) almost every year. I expect I've already reached that limit this year, due to the other loans I had been paying off. It might be different next year, with just paying off the one loan, but if I pay it off faster, I'll actually end up paying less interest, which means a smaller deduction. Not quite sure how to run the numbers on that...

JJsfr

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Re: Pay Off Student Loan, or Start Investing?
« Reply #3 on: August 25, 2016, 12:23:54 PM »
Financially speaking, you should keep that loan as long as you can at that interest rate, especially if you can count the loan interest as tax deductible.

This assumes of course that every penny of the money you would put against the loan goes towards savings and not toward lifestyle.

sisto

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Re: Pay Off Student Loan, or Start Investing?
« Reply #4 on: August 25, 2016, 01:39:40 PM »
I'd max out HSA for sure. You should also consider maxing tIRAs for both of you. Put the rest towards the loan for peace of mind.

Deimyts

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Re: Pay Off Student Loan, or Start Investing?
« Reply #5 on: August 25, 2016, 01:55:14 PM »
Financially speaking, you should keep that loan as long as you can at that interest rate, especially if you can count the loan interest as tax deductible.

This assumes of course that every penny of the money you would put against the loan goes towards savings and not toward lifestyle.

The money would be withdrawn automatically either way, so it won't get redirected toward lifestyle.

How does inflation factor into this?
As I understand it, if my loan is 3.14%, and our current inflation rate is about 1%, then the inflation-adjusted interest rate is actually 2.14%, right?
But if inflation were 4%, my interest rate would be -0.86%, and I would effectively be getting paid to keep the loan.

And an index fund that would return 5% would, adjusted for 1% inflation, actually have an adjusted 4% return?

And how should I calculate the effect on my taxes? After this year, if I don't accelerate my payments, I should be paying about $50 per month in interest, or $600 per year, gradually decreasing.

Would the tax savings simply be the following?
$600 * Tax Rate = Amount Saved
Or is it more complicated?

I think I'm overthinking this stuff, lol.

I'd max out HSA for sure. You should also consider maxing tIRAs for both of you. Put the rest towards the loan for peace of mind.

Why do you recommend maxing out the HSAs over the 401k or an IRA? Is it just because it functions as a backup emergency fund for medical emergencies, or does it have other advantages?

boarder42

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Re: Pay Off Student Loan, or Start Investing?
« Reply #6 on: August 25, 2016, 02:00:36 PM »
you need to do some more research on investings "either our 401ks or a generic index fund" a 401k is an investment account an index fund is an investment you make in that account.  gor read Jlcollins stock series

so your variable rate currently screams invest.  but once i maxed all tax advantaged accounts it would probably make sense to pay it down instead of going taxable.  below is the what and why stolen from MDMs posts.  covers when to pay down debt and when to invest and the order it should be done.


 the 10 year treasury note is currently yielding 1.5%

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 Traditional IRA or Roth (or backdoor Roth) based on income level   
5. Max 401k (if 401k fees are lower than available in an IRA, or if you need the 401k deduction to be eligible for a tIRA, 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: traditional if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between (or see   
   http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/
   if you want even more details on that topic).  See also
   https://www.bogleheads.org/forum/viewtopic.php?f=2&t=182081,
   http://forum.mrmoneymustache.com/ask-a-mustachian/case-study-overwhelming-student-loan-debt-how-would-you-get-started/msg868845/#msg868845
   and other posts in that thread about exceptions to the rule.
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   


boarder42

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Re: Pay Off Student Loan, or Start Investing?
« Reply #7 on: August 25, 2016, 02:04:36 PM »
also one other advantage HSAs have if they are thru your employer and you salary deduct you will bypass FICA.  for an additional 7% savings in tax.

Deimyts

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Re: Pay Off Student Loan, or Start Investing?
« Reply #8 on: August 25, 2016, 02:05:31 PM »
you need to do some more research on investings "either our 401ks or a generic index fund" a 401k is an investment account an index fund is an investment you make in that account.  gor read Jlcollins stock series

I think the issue is that I don't know the specific term for "buying index funds in a non-tax-advantaged investment account." Is there a more succinct word for that?

boarder42

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Re: Pay Off Student Loan, or Start Investing?
« Reply #9 on: August 25, 2016, 02:08:25 PM »
you need to do some more research on investings "either our 401ks or a generic index fund" a 401k is an investment account an index fund is an investment you make in that account.  gor read Jlcollins stock series

I think the issue is that I don't know the specific term for "buying index funds in a non-tax-advantaged investment account." Is there a more succinct word for that?

we'd just call that investing in a taxable account which if you look at that list above is the last thing you do.  here everyone assumes you're buying low cost index funds mainly from vanguard.

therethere

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Re: Pay Off Student Loan, or Start Investing?
« Reply #10 on: August 25, 2016, 02:11:12 PM »
Now, this is all assuming you max our 401k's, IRA's, and HSA first. Then decide what to do with the leftover money... Brokerage account or Loans. The most optimized way would be to invest in a taxable brokerage account with the excess. If you had the ability to pay 3000 towards loans you're likely in the 25% tax bracket with the last of your money. You should be able to max all your tax advantaged accounts and have some leftover.

VTSAX yields 2% in dividends/year*.85 (capital gains) = 1.7% guaranteed earnings
Loan rate of 3.14%*(.75 to account for tax deduction) = 2.35% effective interest rate.

With this simple view you only need the market to go up ~0.7% on average per year to break even. Anything above that is extra earnings/savings whatever you want to call it. I'm betting the market will go up more than that over the course of your loan. There are some other benefits of brokerage over loan payments too. Including having available cash on hand for an emergency (or opportunities if you're disciplined).

**Now that being said, this is how I worked on my loans but it may not be right for everyone. Its the mathematically correct way. You say you have a desire to just pay the sucker off and be done. In hindsight, I wish I had paid off my loans in full instead of balancing this wonky strategy for the last bit. But I didnt', and now I've just got to stick with it and pay the minimums until my loans are gone. I'm continuously conflicted on whether I made the right decision. If you feel a pull to pay them off and be done with that chapter of your life after a long and grueling payoff then I'd propose the following: Rest of 2016 - max any tax advantaged accounts for the rest of the year for the tax savings. Mainly 401k and HSA. Stop extra loan payments. Starting in 2017, focus the first few months of 2017 on getting the loan paid off. Then up all the tax advantaged accounts the rest of the year. Going forward, follow the 0-9 steps quoted above.
« Last Edit: August 25, 2016, 02:19:54 PM by therethere »

Deimyts

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Re: Pay Off Student Loan, or Start Investing?
« Reply #11 on: August 25, 2016, 02:20:12 PM »
you need to do some more research on investings "either our 401ks or a generic index fund" a 401k is an investment account an index fund is an investment you make in that account.  gor read Jlcollins stock series

I think the issue is that I don't know the specific term for "buying index funds in a non-tax-advantaged investment account." Is there a more succinct word for that?

we'd just call that investing in a taxable account which if you look at that list above is the last thing you do.  here everyone assumes you're buying low cost index funds mainly from vanguard.

Ok, cool.

Also, thanks for that writeup. That's pretty much exactly what I was looking forónot just what to do, but the reasoning behind it so I can apply it to my own situation.

Using the treasury note yield as a benchmark is interesting. Is that because it's so much lower risk compared to other types of investments?

boarder42

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Re: Pay Off Student Loan, or Start Investing?
« Reply #12 on: August 25, 2016, 02:26:11 PM »
It's what most loans are based on say the 30 year mortgage for example it's typically 1.7% higher than whatever that note is yielding.  You may even be able to refi that loan to a fixed rate that's in the 3% range I'm not sure I never had student debt so I don't know that side very much.

therethere

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Re: Pay Off Student Loan, or Start Investing?
« Reply #13 on: August 25, 2016, 02:32:43 PM »
It's what most loans are based on say the 30 year mortgage for example it's typically 1.7% higher than whatever that note is yielding.  You may even be able to refi that loan to a fixed rate that's in the 3% range I'm not sure I never had student debt so I don't know that side very much.

I highly doubt you could refinance to a lower rate unless you have a spectacular amount of other assets to claim or a much higher salary than me (definitely possible). My most recent quote with Earnest for a loan with almost those exact parameters is coming in a 4.75% for a fixed rate with the same payment to balance ratio. For reference, the variable rate quoted is 2.9%.

boarder42

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Re: Pay Off Student Loan, or Start Investing?
« Reply #14 on: August 25, 2016, 02:38:27 PM »
odds are your variable rate will track up with the 10 year note so it will likely always make sense to invest. but you never know.

Deimyts

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Re: Pay Off Student Loan, or Start Investing?
« Reply #15 on: August 25, 2016, 05:20:15 PM »
Quote from: therethere
VTSAX yields 2% in dividends/year*.85 (capital gains) = 1.7% guaranteed earnings
Loan rate of 3.14%*(.75 to account for tax deduction) = 2.35% effective interest rate.

With this simple view you only need the market to go up ~0.7% on average per year to break even. Anything above that is extra earnings/savings whatever you want to call it. I'm betting the market will go up more than that over the course of your loan. There are some other benefits of brokerage over loan payments too. Including having available cash on hand for an emergency (or opportunities if you're disciplined).

This is also very helpful, thanks.

With this simple view you only need the market to go up ~0.7% on average per year to break even. Anything above that is extra earnings/savings whatever you want to call it. I'm betting the market will go up more than that over the course of your loan. There are some other benefits of brokerage over loan payments too. Including having available cash on hand for an emergency (or opportunities if you're disciplined).
It's what most loans are based on say the 30 year mortgage for example it's typically 1.7% higher than whatever that note is yielding.  You may even be able to refi that loan to a fixed rate that's in the 3% range I'm not sure I never had student debt so I don't know that side very much.

I highly doubt you could refinance to a lower rate unless you have a spectacular amount of other assets to claim or a much higher salary than me (definitely possible). My most recent quote with Earnest for a loan with almost those exact parameters is coming in a 4.75% for a fixed rate with the same payment to balance ratio. For reference, the variable rate quoted is 2.9%.

Yeah, every time I've looked at refinancing or consolidation, nobody's been offering rates low enough to make it worth it.

sisto

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Re: Pay Off Student Loan, or Start Investing?
« Reply #16 on: August 25, 2016, 05:52:57 PM »
boarder42 answered your questions to me with MDMs list of the order of investing.