Author Topic: Reasons to invest vs pay off loan  (Read 1438 times)

sizzlinkola

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Reasons to invest vs pay off loan
« on: August 19, 2019, 07:09:41 PM »
What's the reasoning behind investing instead of paying down low interest?

I have ~$70k across 401k and Roth IRA. I have federal student loan at $17k with 3.4%. Thus, my NW is $53k.

If I choose to invest $19k into my 401k and assume the average rate of return of 7%, my 401k grows to $95k. My student loan goes up to $17.6k with the 3.4% interest. That puts my NW at $77.4k.

If I choose to pay off my loan in one year, my 401k grows to $75k and that becomes my NW.

EDIT: 401k is better for my NW, but I still have the loan. What would make investing into my 401k the better option?
« Last Edit: August 19, 2019, 07:25:20 PM by sizzlinkola »

arebelspy

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Re: Reasons to invest vs pay off loan if my NW increases in the latter?
« Reply #1 on: August 19, 2019, 07:15:21 PM »
If I choose to pay off my loan in one year, my 401k grows to $75k...but my NW goes up to $92k after paying off my loan since it's a guaranteed return.

If your investments are 70k, you wipe out the student loan... How do you get to 92k in that scenario?

At that time your NW should only be 75k (your 401k balance), lower than the 77.4k in the other scenario.
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use2betrix

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Re: Reasons to invest vs pay off loan if my NW increases in the latter?
« Reply #2 on: August 19, 2019, 07:15:57 PM »
Your math is off.. If you pay off your loan, your net worth grows to $75k... You are somehow adding your paid off loan income to your net worth, when in actuality you just donít subtract it anymore.

sizzlinkola

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Re: Reasons to invest vs pay off loan if my NW increases in the latter?
« Reply #3 on: August 19, 2019, 07:26:54 PM »
If I choose to pay off my loan in one year, my 401k grows to $75k...but my NW goes up to $92k after paying off my loan since it's a guaranteed return.

If your investments are 70k, you wipe out the student loan... How do you get to 92k in that scenario?

At that time your NW should only be 75k (your 401k balance), lower than the 77.4k in the other scenario.

Your math is off.. If you pay off your loan, your net worth grows to $75k... You are somehow adding your paid off loan income to your net worth, when in actuality you just donít subtract it anymore.

Thanks for pointing that out. Yes, it's a ~2.5k difference. However, I still have the loan looming over me. Since I can pay off the loan within a year, what are other reasons to invest?
« Last Edit: August 19, 2019, 07:34:07 PM by sizzlinkola »

use2betrix

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Re: Reasons to invest vs pay off loan if my NW increases in the latter?
« Reply #4 on: August 19, 2019, 07:41:48 PM »
If I choose to pay off my loan in one year, my 401k grows to $75k...but my NW goes up to $92k after paying off my loan since it's a guaranteed return.

If your investments are 70k, you wipe out the student loan... How do you get to 92k in that scenario?

At that time your NW should only be 75k (your 401k balance), lower than the 77.4k in the other scenario.

Your math is off.. If you pay off your loan, your net worth grows to $75k... You are somehow adding your paid off loan income to your net worth, when in actuality you just donít subtract it anymore.

Thanks for pointing that out. Yes, it's a ~2.5k difference. However, I still have the loan looming over me. Since I can pay off the loan within a year, what are other reasons to invest?

Well, you didnít take into consideration the tax benefits of the 401k. Do you have a match? Because that is a HUGE contributing factor.

In terms of taxes, to pay of a $19k loan, you might have to actually make $23k, then after taxes youíd have $19k to pay off the loan. If you put the $19k in the 401k, that is all pre-tax money. So you only have to make $19k to invest that $19k. Not to mention, it grows tax free and you can withdraw it at retirement, tax free.

MDM

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Re: Reasons to invest vs pay off loan if my NW increases in the latter?
« Reply #5 on: August 19, 2019, 08:10:27 PM »
Thanks for pointing that out. Yes, it's a ~2.5k difference. However, I still have the loan looming over me. Since I can pay off the loan within a year, what are other reasons to invest?
The objective reason to invest money in any case, including this one, is to generate a higher return on that money than one could earn otherwise.

If the word "looming" accurately describes the subjective feeling you have about a loan you could pay off in under a year, the subjective benefit of being debt free might compensate you for a lower net worth.  For some that will be true; for others having debt that is being paid off on some schedule bothers them not at all.

One can always look back it time to see whether an early debt payoff would have provided a higher return than investing.  It's just that one cannot determine in advance whether an expected higher but speculative return will outperform a known lower return.

One other thing about a 401k: the annual limit is just that - an annual limit.  One can't "double up" in a subsequent year to make up for lower current contributions.

sizzlinkola

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Re: Reasons to invest vs pay off loan
« Reply #6 on: August 20, 2019, 12:24:34 AM »
Thanks for pointing that out. Yes, it's a ~2.5k difference. However, I still have the loan looming over me. Since I can pay off the loan within a year, what are other reasons to invest?
The objective reason to invest money in any case, including this one, is to generate a higher return on that money than one could earn otherwise.

If the word "looming" accurately describes the subjective feeling you have about a loan you could pay off in under a year, the subjective benefit of being debt free might compensate you for a lower net worth.  For some that will be true; for others having debt that is being paid off on some schedule bothers them not at all.

One can always look back it time to see whether an early debt payoff would have provided a higher return than investing.  It's just that one cannot determine in advance whether an expected higher but speculative return will outperform a known lower return.

One other thing about a 401k: the annual limit is just that - an annual limit.  One can't "double up" in a subsequent year to make up for lower current contributions.

Right, another way to frame it is that the loan will give me a 3.8% guaranteed return. While the assumed return from my 401k is not guaranteed.

Yes, you can't double-up and I would miss out on $19k this year. However, what do I miss if I don't put in the $19k? From a FIRE calc, it'd take 3-6 months longer to retire. 

use2betrix

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Re: Reasons to invest vs pay off loan
« Reply #7 on: August 20, 2019, 06:53:36 AM »
Thanks for pointing that out. Yes, it's a ~2.5k difference. However, I still have the loan looming over me. Since I can pay off the loan within a year, what are other reasons to invest?
The objective reason to invest money in any case, including this one, is to generate a higher return on that money than one could earn otherwise.

If the word "looming" accurately describes the subjective feeling you have about a loan you could pay off in under a year, the subjective benefit of being debt free might compensate you for a lower net worth.  For some that will be true; for others having debt that is being paid off on some schedule bothers them not at all.

One can always look back it time to see whether an early debt payoff would have provided a higher return than investing.  It's just that one cannot determine in advance whether an expected higher but speculative return will outperform a known lower return.

One other thing about a 401k: the annual limit is just that - an annual limit.  One can't "double up" in a subsequent year to make up for lower current contributions.

Right, another way to frame it is that the loan will give me a 3.8% guaranteed return. While the assumed return from my 401k is not guaranteed.

Yes, you can't double-up and I would miss out on $19k this year. However, what do I miss if I don't put in the $19k? From a FIRE calc, it'd take 3-6 months longer to retire.

Why make the cutoff 3.8% return? You could also say the same for 1% that the 401k isnít ďguaranteed.Ē

Itís largely just a risk factor tolerance. It sounds like you are very risk adverse and thatís fine too, but you will likely suffer some returns on investment over your lifetime. Everyone has their cutoff, and it is very important that someone is able to make choices that will not induce a ton of stress while thinking about it every day.

PlainsWalker

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Re: Reasons to invest vs pay off loan if my NW increases in the latter?
« Reply #8 on: August 20, 2019, 01:39:42 PM »
In terms of taxes, to pay of a $19k loan, you might have to actually make $23k, then after taxes youíd have $19k to pay off the loan. If you put the $19k in the 401k, that is all pre-tax money. So you only have to make $19k to invest that $19k. Not to mention, it grows tax free and you can withdraw it at retirement, tax free.

I realize that you probably mean if you manage your withdrawals well then you can reduce your tax liability to zero when withdrawing from a tax advantaged account. From the government's perspective tax advantaged personal retirement accounts are tax saving accounts. The tax that would normally be owed when the money was earned was deferred because the individual did the thing that was being encouraged and saved it in a tax advantaged account. Then when they go to withdraw the money the government is owed taxes on the distribution. It sounded for a moment like tax evasion was being prescribed when in fact tax avoidance via carefully following the tax code was probably the intent.

sizzlinkola

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Re: Reasons to invest vs pay off loan
« Reply #9 on: August 21, 2019, 12:42:13 AM »
If you want an accurate answer you need to give us more info.

1) Does your employer give you a match? You should always invest up to the match percentage as that is an immediate 100% return on your own investment.

2) What is your income/tax bracket? If you are planning to FIRE relatively early and can live on modest amounts you will be able to convert traditional retirement accounts to Roths at low or no tax rates, so it is probably advantageous to shelter as much as you can now.

It doesn't have to be all or nothing. Put a decent amount, at least up to company match, into retirement and throw the rest at the loan.

1) Yes, I am getting up to the 4% match.

2) My income is $85k in NYC.

Yes, it doesn't have to be all or nothing. But with the remaining months of this year, this is my only shot for putting in another $19k into my 401k. When Jan 2020, I can definitely max out and pay off majority of my loan.

arebelspy

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Re: Reasons to invest vs pay off loan
« Reply #10 on: August 21, 2019, 08:18:56 AM »
Yes, it doesn't have to be all or nothing. But with the remaining months of this year, this is my only shot for putting in another $19k into my 401k. When Jan 2020, I can definitely max out and pay off majority of my loan.

Do the 401k now. Take the match, and the tax benefits. Next year you can pay it off and still max? Great. Pay it off then.

A lot of people would argue to invest at taxable rather than 3.4% debt at that point, but emotions matter too, and you seem inclined to want to pay it off. That's fine.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

BlueHouse

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Re: Reasons to invest vs pay off loan
« Reply #11 on: August 26, 2019, 10:09:09 AM »
Yes, it doesn't have to be all or nothing. But with the remaining months of this year, this is my only shot for putting in another $19k into my 401k. When Jan 2020, I can definitely max out and pay off majority of my loan.

Do the 401k now. Take the match, and the tax benefits. Next year you can pay it off and still max? Great. Pay it off then.

A lot of people would argue to invest at taxable rather than 3.4% debt at that point, but emotions matter too, and you seem inclined to want to pay it off. That's fine.
+1.  This is the ONLY chance you get to fill up your 401K for this year.  You never get another chance to do 2019 again.