Author Topic: What's the interest rate cut-off for paying down debt vs. investing?  (Read 2648 times)

studentdoc2

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My partner and I are currently in the position -- as I'm sure many others are -- of simultaneously paying down undergraduate student loans (while graduate students) and starting to save for retirement. I vacillate back and forth between thinking we should direct all our extra money towards student loans and splitting the money between paying off student loans vs. saving for retirement.

The options:
~$75,000 in student loans varying from 2-6.8% interest. All are in deferment (no payments required) and some (~$20,000) are subsidized (no interest accruing). Because they are in deferment (and will be for 1-4 years), we can't consolidate to a lower interest rate.
ROTH IRAs -- possible max contribution of $11,000/yr.
Individual 401(k) -- just realized I could open one (side job as a contractor), but haven't done so as we'll be in the 15% tax bracket anyway and couldn't drop any further. (obviously, we have no option for a company match)

Right now, we have ~$2000/mo that we could throw at loans or savings. Currently, we split it about evenly between both to max out the IRAs and are attacking the highest non-subsidized interest rate loans first. However, I wonder if we should divert all extra money towards the loans until we are left with only lower interest rate loans (which would be what? 5% interest rates? 4%? 3%?).

I understand that one would pay off consumer debt at high interest rates before investing and that one would probably (but not always) invest before paying down a low interest mortgage early, but I'm confused as to where the dividing line between paying down debt early and investing in retirement should be.... I understand it's effectively betting against unsure returns in your retirement accounts (but ~7% average) vs. immediate returns equal to the interest rate of the loans (again, 2-6.8% in our case), but shouldn't one also consider the length of time those investments have to accrue? (many years in our case as we're just starting out)

Any thoughts would be much appreciated!

MDM

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Re: What's the interest rate cut-off for paying down debt vs. investing?
« Reply #1 on: June 20, 2014, 09:02:34 PM »
Appears you understand quite well.

Let's play what-if?:

a) $75,000 loan, 5.1228% over 10 years.  Payment = $800/mo  (oddball interest rate to make round payment).  Extra $1,200/mo invested at 7% compounded monthly.
    After 10 years, the loan is paid (including $21,000 interest) and the investment has grown to $207,700.

b) $75,000 loan, 5.1228% over 10 years.  Payment = $800/mo, with $1,200/mo to pay down principal.  After loan paid, $2,000/mo invested at 7% compounded monthly.
    Loan paid in 41 months (including $6,900 interest).  After 79 months investing (and 80 months return from $100 left over after loan payoff), the investment has grown to $200,100.

But if the investment return is 4% instead of 7%, a) grows to $177,700 while b) is $180,500.

All the above just reinforces that you "should" put your money toward the item paying (or charging) the highest interest rate.  But, as you state, the market returns are "unsure" - and then there's the whole philosophical thing about being debt-free or not worrying about being debt-free.

Anyway, back to the original point: it appears you understand the issues and trade-offs so the choice really is up to you.  Either way you will be better than spending the extra money on mocha double lattes or similar.

gooki

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Re: What's the interest rate cut-off for paying down debt vs. investing?
« Reply #2 on: June 21, 2014, 02:30:37 AM »
The simple answer 5%.

frugaliknowit

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Re: What's the interest rate cut-off for paying down debt vs. investing?
« Reply #3 on: June 21, 2014, 08:24:38 AM »
Keep in mind that paying off a loan is equivalent to a risk free rate of return as opposed to a risky rate of return.  While stocks or stock index fund returns are likely to be double digit in the long run, they are not risk free returns.  The payment of debt is akin to buying a risk free bond or insured CD.  You might even think of it as the bond portion and certainly the no risk portion of your portfolio.

Thedudeabides

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Re: What's the interest rate cut-off for paying down debt vs. investing?
« Reply #4 on: June 21, 2014, 10:06:34 AM »
Just out of curiosity, why don't you have the option for employer contribution with your solo 401k? Should be able (legally) to contribute up to 20% of earned income + $17,500 contributions.

Depending on your retirement goals, this could be the best option. You are in the 15% tax bracket right now, so this would give you an immediate 15% return since it's pretax. You'll also be able to contribute more up front so more time for compounding. When you're ready for RE, you could convert the 401k to traditional IRA and then setup a ROTH conversion ladder.

Joel

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Re: What's the interest rate cut-off for paying down debt vs. investing?
« Reply #5 on: June 21, 2014, 10:13:26 AM »
Somewhere between 4-6% depending on one's circumstances.