Author Topic: What to do with very low interest debt  (Read 3834 times)

bjack2

  • 5 O'Clock Shadow
  • *
  • Posts: 10
What to do with very low interest debt
« on: May 08, 2014, 12:50:41 PM »
Hello
A pre-emptive thank you to the moustachians that answer this.  I am very new to all of this but completely obsessed with the blog and my wife and I are on board with moving our lives toward moustachianism.  Here is our situation:  Other than our mortgage (after reading this blog we refinanced to a 15 year at 3.6% and thus have saved ourself 125K!!!) the only debt we have is my medical school debt.  The good news is I locked it in at 2.6% when I finished school 9 years ago.  We have no other debt, relatively high salaries, and our lifestyle was pretty frugal to begin with but getting better with each MMM blog post.  I love my job (3 days / week) and never want to work more or less until I get too old to make good decisions for my patients.  I spend the other 4 days of the week hanging with my two young kids, playing guitar, homebrewing, etc.  My wife is in academic medicine and works more but also loves her job and so early retirement isnt really something we ever want to do.  I understand the psychological advantage of not having to work so we are speding less, investing more, etc.  My question is should I try and pay off the low interest debt (currently 89K with 20 more years on the loan).  Conventional wisdom says invest because any extra money will grow at a greater rate than our current loan interest rate.  Thoughts?  Thanks,
Ben
ps - My wife just cut my hair with a UMGD and it looks money.  Cant believe I have been spending 25 bucks a month on that!!!

nawhite

  • Handlebar Stache
  • *****
  • Posts: 1057
  • Location: An RV somewhere in the West
    • The Reckless Choice
Re: What to do with very low interest debt
« Reply #1 on: May 08, 2014, 01:05:53 PM »
The math looks like this

CAGR (compound annual growth rate) of the investment - inflation - student loan interest rate = effective rate you would expect to get investing your money instead of paying off the loan.

With numbers:
9.1% (historical average SP500 CAGR) - 3.22% (historical average US inflation rate since 1913) - 2.6% (fixed right?) = 3.28% average expected annual return on a dollar invested vs a dollar put towards the loan

So now we know you should get an average 3.28% better return by investing. But now you need to take risk into account. The Student loan gives you a guaranteed return of 2.6% plus inflation. The stock market could give you +30% or it could give you -20% in a single year (easily). So averaged over 100 years, you'll probably end up in the black, but there is also a chance you'll be left with half the money you put away and still have the loan.

In this situation, I'd personally probably max out all tax deferred retirement accounts (401k, IRA, HSA) and then I'd put the rest toward the loans. But it is a personal question based on how risk averse you are and what you expect the market and inflation to do in the medium term.

Edit: I used the wrong number for CAGR
« Last Edit: May 08, 2014, 01:28:19 PM by nawhite »

waltworks

  • Magnum Stache
  • ******
  • Posts: 3235
Re: What to do with very low interest debt
« Reply #2 on: May 08, 2014, 01:22:30 PM »
Just an emotional decision, really. At 2.6% I wouldn't pay it off if you were trying to maximize your returns and had a long term approach to investing, but I'm an optimizer and not too concerned about taking on some short term risk. If just having the debt is annoying to you and/or it's a waste of time to send a check every month or whatever, then sure, pay it off.

In your situation, it sounds like what will make you happiest is the most important thing, which might or might not be the financially optimal solution.

-W

nereo

  • Senior Mustachian
  • ********
  • Posts: 10309
  • Location: la belle province
    • Here's how you can support science today:
Re: What to do with very low interest debt
« Reply #3 on: May 08, 2014, 01:30:20 PM »

With numbers:
6.8% (historical average SP500 CAGR) - 3.22% (historical average US inflation rate since 1913) - 2.6% (fixed right?) = 0.98% average expected annual return on a dollar invested vs a dollar put towards the loan
Not sure I agree with your numbers:
Annual return (dividends reinvested) since 1913 has been 9.85%
Annual return (dividends reinvested) inflation adjusted (CPI):6.45%

Ergo: using historical "averages" the math works out like this: 6.45% (historical returns on SP500) - 2.6% (SL) = 3.85%
That makes a much stronger case for investing the difference.  Also, SL interest is tax deductable, which could be $2,300 on $89k of debt at 2.6%.  Depending on your other deductions and AGI this could reduce your tax bill by $320-575.

As nawhite mentioned, this is just a long-term market average.  Markets can go -30% of +30% on any given year.  Over 15 year time periods though the SP500 has always beaten inflation, and almost always done better than 2.6.

bjack2

  • 5 O'Clock Shadow
  • *
  • Posts: 10
Re: What to do with very low interest debt
« Reply #4 on: May 08, 2014, 02:58:39 PM »
Thanks so much.  Now the key is actually investing it wisely and not spending it on vacations or house renovations!
Ben

nereo

  • Senior Mustachian
  • ********
  • Posts: 10309
  • Location: la belle province
    • Here's how you can support science today:
Re: What to do with very low interest debt
« Reply #5 on: May 08, 2014, 07:25:14 PM »
Thanks so much.  Now the key is actually investing it wisely and not spending it on vacations or house renovations!
Ben
exactly.  the biggest concern when someone chooses not to rapidly pay down low interest debt is that they spend that money instead of save it.  If you are worried that is what you might do, then pay down that loan instead.  know thyself ;-)

Emg03063

  • Bristles
  • ***
  • Posts: 458
Re: What to do with very low interest debt
« Reply #6 on: May 08, 2014, 07:32:48 PM »
Keep in mind if you're able to deduct your student loan interest, your effective rate is even lower than 2.6%

t-rymz

  • 5 O'Clock Shadow
  • *
  • Posts: 29
Re: What to do with very low interest debt
« Reply #7 on: May 08, 2014, 08:38:35 PM »
I don't quite agree with these posts. First, the math is a bit shaky. The 2.6% is (almost certainly) before inflation money. So, the return of investing your money in mutual is about 9.6 - 2.6 = 7%.

7% is the marginal cost of putting the money into your loan. It's true the value of that money will decrease with inflation. But you can't compare a 10% after inflation with a 3% loan before inflation. Either the loan is -0.4% (after inflation - free money!) or your returns are 10%.

Anyways, that's a big return. And your loan is costing (after inflation) nothing. So the best course of action is to drag the loan out and put the money into stock funds. It's what an engineer would suggest. Convince yourself it's worth it by thinking about how much that money will be worth in ~30 years. More than having no debt.

Just make sure you save it.

frugal_engineer

  • 5 O'Clock Shadow
  • *
  • Posts: 88
Re: What to do with very low interest debt
« Reply #8 on: May 09, 2014, 06:19:06 AM »
Based on dual medical incomes, they won't be deducting any student loan interest - thats gone at ~$75k for single, $150k (?) for married id imagine.

nereo

  • Senior Mustachian
  • ********
  • Posts: 10309
  • Location: la belle province
    • Here's how you can support science today:
Re: What to do with very low interest debt
« Reply #9 on: May 09, 2014, 07:03:33 AM »
Based on dual medical incomes, they won't be deducting any student loan interest - thats gone at ~$75k for single, $150k (?) for married id imagine.
You are correct - I had to look up the amounts because I haven't ever exceeded $155k filing jointly.
http://www.irs.gov/publications/p17/ch19.html
However, I wouldn't assume that their adjusted gross income would be >$155k, even as two medical professionals.  Hopefully they are taking advantage of tax-advantaged accounts, which could reduce their AGI by $50k or more.  Just sayin', two incomes in the medical sector is far from a sure $200k+ income these days.

FuckRx

  • Pencil Stache
  • ****
  • Posts: 788
Re: What to do with very low interest debt
« Reply #10 on: May 09, 2014, 07:45:25 AM »
The math looks like this

With numbers:
9.1% (historical average SP500 CAGR) - 3.22% (historical average US inflation rate since 1913) - 2.6% (fixed right?) = 3.28% average expected annual return on a dollar invested vs a dollar put towards the loan


....minus whatever tax you would pay on that leftover 3.28%, with their income it might be a nice chunk.