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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: calamityb on July 14, 2014, 07:17:25 PM

Title: Student loan payments vs IRA contributions
Post by: calamityb on July 14, 2014, 07:17:25 PM

I'm a 26 y/o professional and budding Mustachian wondering about the value of paying off my student loans v. making contributions to my Roth IRA account. I generally understand the principle of paying off high interest loans, but I think I need help understanding the math and calculating where I should be putting money to make it work for me best.

Student loans: $12,077 at 6.8% fixed
I was paying minimum $125/month but realized I should pay more like $500, so I recently dumped a couple thousand into the payments and also increased my monthly payment.

Roth IRA (value): $2,611
I contribute $300/month, which just over 10% of monthly take-home income
I have $111 in returns since inception - February 2014, so approx $2500 is my own contribution. I work for a nonprofit; no contributions are matched and there is no 401k program.

Question: Should I redirect  all $800 (student loan payment + retirement contribution) into my student loans to be debt free faster?
I wasn't sure how to figure this out, so I made an excel sheet and played out paying $500/month for 1 year versus paying $800/month for the same period. Paying $500/month: at the end of one year, my principal was reduced $5815.77 with actual payments totaling $6000. Paying $800/month: at the end of one year, my principal was reduced $9849.13 with total payments totaling $9600.

I know that paying more will result in significantly lower total at the end, but is there more data I should be playing around with? Is there a net "gain" I can see from paying off loan faster? At a loss for useful math, I thought it would be interesting to see the difference in the amount of my payments used against the principal in either scenario, so I divided each ending principal by the amount paid over 1 year, which gave me a percentage of the payments that was actually paid against the principal, but it was a (seemingly) negligible 96.9% (in the $500 scenario) versus 97.47% (in the $800 scenario).

I'm also not sure how to compare all this against my Roth IRA, which does not have a fixed interest rate by which to calculate growth. I know that the stock market is variable, but can I use rough 4.4% interest in a calculation? (111 in gains /2500 purchases). If so, what calculation might I make?

I guess my overall question is: if I have $800/month to put toward reducing my student loans or growing Roth IRA, how should I use that money?

Other context: I want to reduce debt so I have good debt-to-income ratio to buy property. My credit score is currently around 750. I have no other debts, and a car worth $2500. I have money saved for 6 months of expenses. I haven't addressed saving for a down payment, because I figured getting out of debt was more important. But I'm also thinking about how buying property would also redirect money from rent into (hopefully small!) mortgage, which means saving that down payment should also be a goal.

Subquestion: If the right answer to above question is throwing all money at student loans, is there also a sweet spot at which the difference might be negligible (as student loan interest accrual decreases each month), and I could start putting money back into investments/savings?

Thanks for any help/insight!

Title: Re: Student loan payments vs IRA contributions
Post by: Joel on July 14, 2014, 07:41:41 PM
The student loan offers a very attractive guaranteed return.
Title: Re: Student loan payments vs IRA contributions
Post by: ragnathor on July 14, 2014, 07:53:17 PM
This is an interesting question, and the answer will depend. Personally, I would split it 50/50 ($400 to each of student loans and IRA). Here is why:

If you were contributing to a regular brokerage account, I would say contribute all to the student debt. This is a guaranteed 6.8% return paying the debt down. For expected investment return, I like to use 6% (this may be liberal though, many on here probably use 4%, some use 10%). However, any contributions you make to the Roth IRA will be tax free. Let's say you use the 4% number and have a 25% tax rate, that's 1% per year you are making more than if you contributed to a regular brokerage for however many years before you withdraw from the IRA.

In the end I think the dollar amounts are not going to vary that much whichever way you go and are very difficult to predict. That's why I think splitting in 50/50 gives you the psychological benefit of paying down your debt and building up your IRA.
Title: Re: Student loan payments vs IRA contributions
Post by: viper155 on July 14, 2014, 08:35:33 PM
The student loan offers a very attractive guaranteed return.

This is sarcasm I hope. Loans don't have returns, they suck you dry. Pay the loans off first. Get a second job if you have to until they are gone. Then bomb all that money into your investments. Debt sucks
Title: Re: Student loan payments vs IRA contributions
Post by: Joel on July 14, 2014, 08:40:38 PM
What's done is done. This person has two choices for their investments going forward. 1) invest in paying down the student loan with a guaranteed 6.8% return or 2) invest in the market and hope to return at least 6.8%. At this point in time, paying down the debt is a guaranteed return. Doesn't have anything to do with whether or not the debt should have been taken on initially or not, but that's a decision in the past that you cannot change. If the interest rate was less than 3%, I personally would not pay it down early at all.
Title: Re: Student loan payments vs IRA contributions
Post by: krishnamba on July 14, 2014, 08:45:05 PM
You are 26 so I would recommend you put away the full $5,500 in Roth IRA that would be $458 a month April to April.

Money always compounds up when building wealth. When paying debt so long as it includes principal will wind down and have no great detriment to your long term wealth building.

Finally do not take it wrong way but I advise you to after getting 1 year experience move on to a company with 401k match.

Place the full 17,500 and then the 5,500 in to Roth IRA even if you need to use backdoor.
Pay your minimum on student loans and if you plan to have children start a 529 on your name and try to put up to 5,500 a year in that.

Total Savings = 17,500 + 5,500 + 5,500 = 28,500

lo and behold in 15 years you will be financially independent as you learn how to live below your means, have a family and do other live your life stuff.