Author Topic: When not to pre-pay loans?  (Read 7049 times)

irrational

  • 5 O'Clock Shadow
  • *
  • Posts: 25
When not to pre-pay loans?
« on: December 06, 2013, 04:32:07 PM »
Mustachians I've been planning out my next 12 months of my game plan, and I come to you with a question.

Most everyone here seems anti-debt (and rightfully so), but surely pre-paying a loan isn't always the "right" move. For example, I have student loans @ 2.9% interest with about 35K balance and 19 years remaining (I just started repaying them this year).

In planning my next 12 months, it'd seem to me that paying more than the minimum on these loans is a worse move than (say) putting the same money twords my IRA.

More concrete numbers:

Take home pay: $2,400 bi-weekly.

Come July/august I'll be free of all consumer debt. The plan is to take the snowball I've been using for that ($650/mo) and max out my IRA (about $450/mo). Leaving me with the choice of opening an IRA in my wife's name for the remaining $200/mo, or paying down another loan.

This leaves me with the following debts:
Student loans: $199/mo, $35K balance, 2.9% interest, 19 years remaining.
Mortgage (with taxes, insurance, etc): $1,300/mo, $184K balance, 3.5% interest, 29 years remaining.

I see the value, and could be talked into pre-paying my mortgage... But, when I look at the student loans and see an interest rate below 3% with no physical asset attached to it, I just cannot see the value in pre-paying that.

What say you?

Argyle

  • Pencil Stache
  • ****
  • Posts: 909
Re: When not to pre-pay loans?
« Reply #1 on: December 06, 2013, 04:42:09 PM »
Do you have a pre-nup about what happens to your wife's ERA, into which you've deposited $200 a month, in case of divorce?  I know no one starts out planning to get divorced, but there's a not insignificant chance that it could happen.

How much interest would you pay on that $35K over the next nineteen years?  And remember that student loans are not dischargable in bankruptcy.  They will be with you until you pay them off, no matter what.

Since your mortgage interest is deductible, your mortgage rate is actually not appreciably higher than your student loan rate.

I personally enjoy the freedom of having no monthly debt payments.  If you got busy, you could vanquish that student loan debt in two or three years (maybe less if you make a lot).  Then you don't have it hanging over your head when you decide what to do with your money.

Now, some people would borrow money at 2.9% and invest it, hoping to beat the market and make a profit.  (Remember it has to be a profit after taxes.)   But if you just pay off the loan, you get a guaranteed 2.9% profit, which is a higher guaranteed profit than anything you can get commercially these days.  That sure 2.9% by paying off the loan sounds like a good deal to me.

irrational

  • 5 O'Clock Shadow
  • *
  • Posts: 25
Re: When not to pre-pay loans?
« Reply #2 on: December 06, 2013, 04:59:54 PM »
First, thanks for your input!

Do you have a pre-nup about what happens to your wife's ERA, into which you've deposited $200 a month, in case of divorce?  I know no one starts out planning to get divorced, but there's a not insignificant chance that it could happen.

That is a good point, and I appreciate you mentioning it. I failed to mention that we've been married for 9 years, have 3 boys, and I'm the sole bread winner... so, in the remote possibility that we did part ways, I think I'd be a lot more screwed than simply putting $200/mo into an IRA in her name. The idea of an IRA in her name was simply that of trying to save more than $5,500/year into a tax advantaged retirement account.

How much interest would you pay on that $35K over the next nineteen years?  And remember that student loans are not dischargable in bankruptcy.  They will be with you until you pay them off, no matter what.

I believe the interest works out to $11K. For brevity I failed to mention that I'm not a recent grad, despite just recently starting payments on my student loans... the short of it is, I've been up close and personal with how "different" student loans are from every other type of loan.

Since your mortgage interest is deductible, your mortgage rate is actually not appreciably higher than your student loan rate.

I personally enjoy the freedom of having no monthly debt payments.  If you got busy, you could vanquish that student loan debt in two or three years (maybe less if you make a lot).  Then you don't have it hanging over your head when you decide what to do with your money.

Now, some people would borrow money at 2.9% and invest it, hoping to beat the market and make a profit.  (Remember it has to be a profit after taxes.)   But if you just pay off the loan, you get a guaranteed 2.9% profit, which is a higher guaranteed profit than anything you can get commercially these days.  That sure 2.9% by paying off the loan sounds like a good deal to me.

These are very good points, and exactly why I floated this out there. In my mind I was thinking:

Stock market could average around 7% less student loans at 2.9% which means a realized return of 4.1% if I left the student loans as-is and took advantage of more retirement savings options.

Argyle

  • Pencil Stache
  • ****
  • Posts: 909
Re: When not to pre-pay loans?
« Reply #3 on: December 06, 2013, 05:07:20 PM »
The stock market could average 7%, but will it?  And if you get a 4% profit, what's your tax rate?  Say it's 25% which means a net 3% profit, still kind of iffy because it depends on several variables.  Well, you get could a guaranteed extra 3% profit by pre-paying your mortgage in addition to your student loans. 

And if things go south with your wife -- not saying they will, just if -- you may be screwed in more ways than just her IRA -- but you'll be screwed that way too, won't you?  Saying "Yeah, but that hardly compares to the other losses I'd have" doesn't make it any less a loss.  You may decide it doesn't matter and you're willing to take the risk, and that's fine, but just to say that other risks don't make it not a risk.

TrulyStashin

  • Handlebar Stache
  • *****
  • Posts: 1030
  • Location: Mid-Sized Southern City
Re: When not to pre-pay loans?
« Reply #4 on: December 06, 2013, 05:12:35 PM »
Your wife is a SAHM and deserves to have an IRA specifically for her.  She adds value to your family and therefore should have a retirement fund of her own, in her name, funded with FAMILY money.

I agree with your thoughts on the SL debt.  I'd let it ride and max out all tax-advantaged retirement accounts before paying it down.

Chiron

  • 5 O'Clock Shadow
  • *
  • Posts: 67
Re: When not to pre-pay loans?
« Reply #5 on: December 06, 2013, 05:14:40 PM »
This always comes down to the borrower's risk tolerance.  Paying down your student loans is the "safest" option.  It will give you a guaranteed return of 2.9%*.  If you invested in say, the stock market, you could reasonably expect earn much higher than that over a long time period.  Of course this is subject to capital gains tax*.   Of course, the catch is that the stock market is volatile and could go up or down in any given year. 

I can't tell you what you should do, but I can tell you that it would be most helpful to figure out the exact returns you're expecting on an after-tax basis and weigh the risks v. rewards.  I'll tell you that I personally, given my age, risk tolerance, future goals, and comfort with leverage, would make the minimum payments on that debt and invest it into tax-advantaged accounts first, then taxable accounts. 

*You seem to be near some important income thresholds for tax purposes.  Check to see if you can deduct the interest on your student loans (which reduces your effective rate of interest and is a further point against paying them off early) and if you would pay long term capital gains tax on your investments (you don't have to if you are in the 15% bracket currently - this is more applicable for taxable investment accounts since the tax-advantaged ones have other considerations).   

brewer12345

  • Handlebar Stache
  • *****
  • Posts: 1386
Re: When not to pre-pay loans?
« Reply #6 on: December 06, 2013, 05:17:19 PM »
Student loan debt is the one obligation I would pay off regardless of rate.  This is about the only debt that cannot be discharged in bankruptcy.  Pay it off.

impaire

  • Stubble
  • **
  • Posts: 241
Re: When not to pre-pay loans?
« Reply #7 on: December 06, 2013, 05:20:54 PM »
Your wife is a SAHM and deserves to have an IRA specifically for her.  She adds value to your family and therefore should have a retirement fund of her own, in her name, funded with FAMILY money.

I agree with your thoughts on the SL debt.  I'd let it ride and max out all tax-advantaged retirement accounts before paying it down.
My thoughts exactly, on both points.

msilenus

  • Pencil Stache
  • ****
  • Posts: 517
Re: When not to pre-pay loans?
« Reply #8 on: December 06, 2013, 05:34:54 PM »
Your loans are at 2.9% fixed for 19 years.  I'm pretty sure that if you simulated paying that debt down, versus putting similar amounts into the stock market for every 19-year period over the last hundred years, you wouldn't find a single one which paying down the debt came out ahead.  That's comparing post-tax debt payments to post-tax market investments.

That's the wrong comparison, of course.  The right comparison is comparing post-tax debt payments to pre-tax market investments growing tax deferred.  To run those numbers, one would need your marginal tax rate, but the simulation would come out even worse for paying down the debt no matter what.

Personally, I think even considering paying down that loan is a little ridiculous given your age and time horizon.

BTW, one factoid that really helps explain the intuition for why the market is going to win these simulations is that dividends are about 2%, and aren't nearly as elastic on the downside as stock prices are.  Dividends alone will take you most of the way to breaking even with debt payments.  The time horizon crushes what's left.
« Last Edit: December 06, 2013, 05:39:58 PM by msilenus »

irrational

  • 5 O'Clock Shadow
  • *
  • Posts: 25
Re: When not to pre-pay loans?
« Reply #9 on: December 06, 2013, 07:13:23 PM »
Thanks All! This is some really good feedback. Exactly the type of thoughts I was looking for.

Very interesting regarding the idea of risk tolerance. I'd never thought of it that way, but yes, as a 30 year old I'm more interested in taking on more risk for potentionally higher returns.

2) Do you have PMI? If so then your effective mortgage rate is much higher. My PMI makes my effective mortgage rate go from 3.5% to 7%. If you do have it I can explain the math behind getting your effective rate

I'd never thought to question the effect of mortgage insurance on effective rates. We have an FHA loan, so it's technically not PMI... But, it does have some type of insurance attached to it. Also, unlike PMI, it's for the life of the loan (or until we refi as a non-FHA loan).

Regardless, I'm very curious now and would be interested in hearing how this changes things.

tariskat

  • Bristles
  • ***
  • Posts: 307
Re: When not to pre-pay loans?
« Reply #10 on: December 06, 2013, 07:30:04 PM »
On student loans,

...I personally would pay down the debt because I would HATE a $35k loan hanging over my head for 19 years.

...

1) Quite a few people on here are adamant that student loans are bad to carry because you can't bankrupt them but I'd argue that they are better than other debts to carry because you have so many more options if you do end up in financial trouble. You can put them in forbearance or get on income based repayments


I have to agree here on both points.  You cannot bankrupt a student loan, but repaying becomes super flexible because the banks would rather have a little than nothing.  I'd attack it after opening another IRA - I agree your SAHM should have as much IRA love as you do for all her work - but I'd still go like crazy after the IRA contributions.  You already paid for your schooling - there is no reason to give them another 11,000$ if you can help it.  That's equivalent to a year of school for one of your children.

RobertBirnie

  • 5 O'Clock Shadow
  • *
  • Posts: 77
  • Age: 32
  • Location: San Jose, CA
Re: When not to pre-pay loans?
« Reply #11 on: December 06, 2013, 07:48:48 PM »
Mustachians I've been planning out my next 12 months of my game plan, and I come to you with a question.

Most everyone here seems anti-debt (and rightfully so), but surely pre-paying a loan isn't always the "right" move. For example, I have student loans @ 2.9% interest with about 35K balance and 19 years remaining (I just started repaying them this year).

In planning my next 12 months, it'd seem to me that paying more than the minimum on these loans is a worse move than (say) putting the same money twords my IRA.

More concrete numbers:

Take home pay: $2,400 bi-weekly.

Come July/august I'll be free of all consumer debt. The plan is to take the snowball I've been using for that ($650/mo) and max out my IRA (about $450/mo). Leaving me with the choice of opening an IRA in my wife's name for the remaining $200/mo, or paying down another loan.

This leaves me with the following debts:
Student loans: $199/mo, $35K balance, 2.9% interest, 19 years remaining.
Mortgage (with taxes, insurance, etc): $1,300/mo, $184K balance, 3.5% interest, 29 years remaining.

I see the value, and could be talked into pre-paying my mortgage... But, when I look at the student loans and see an interest rate below 3% with no physical asset attached to it, I just cannot see the value in pre-paying that.

What say you?

With my loans I personally feel that in order to stretch such a low interest out over so many years that the payments are super low. Sure I could get a higher return in the stock market, but increasing the payment by $20/mo probably cuts years off the loan without being a change that my pocket book will even notice (and neither your portfolio.

And I'm pretty sure you can deduct the student loan interest but it has a fairly low maximum. Personally I'm not over the standard deduction so it doesn't even matter for me, but if you have a mortgage its worth looking into. I know TurboTax always asks for the info, and my banks send me my tax documents for student debt.

irrational

  • 5 O'Clock Shadow
  • *
  • Posts: 25
Re: When not to pre-pay loans?
« Reply #12 on: December 06, 2013, 07:50:39 PM »
Just throwing this out there...

Why all the fixation on the fact that student loans are not dismissable in bankruptcy? Seems rather anti-mustachian to actually plan for the what-ifs of a BK. If anything, wouldn't a mustachian life style tend to make the probability of needing to BK close to 0?

Daleth

  • Handlebar Stache
  • *****
  • Posts: 1201
Re: When not to pre-pay loans?
« Reply #13 on: December 06, 2013, 07:53:30 PM »
Your wife is a SAHM and deserves to have an IRA specifically for her.  She adds value to your family and therefore should have a retirement fund of her own, in her name, funded with FAMILY money.

I completely agree.

Also, I hope you have life insurance on yourself for her, and on her for yourself. A friend of mine lost his wife very suddenly when they were in their 30s and had two kids under 10. If you want to estimate how much a stay-at-home-mother's work is worth, try hiring someone to get the kids breakfast, get them dressed, make their lunches, take them to and from school, clean the house, and cook dinner every day. The cost is astronomical. Term life insurance whose term ends roughly when the last kid is 18 would be a good idea.
« Last Edit: December 06, 2013, 07:56:04 PM by Daleth »

Cyrano

  • Stubble
  • **
  • Posts: 123
Re: When not to pre-pay loans?
« Reply #14 on: December 06, 2013, 08:22:23 PM »
Just throwing this out there...

Why all the fixation on the fact that student loans are not dismissable in bankruptcy? Seems rather anti-mustachian to actually plan for the what-ifs of a BK. If anything, wouldn't a mustachian life style tend to make the probability of needing to BK close to 0?

Many folks around here assume a high level of physical ability, insourcing work instead of buying services. An unfortunate early disability can derail anyone's plans.

fragglebock

  • 5 O'Clock Shadow
  • *
  • Posts: 24
Re: When not to pre-pay loans?
« Reply #15 on: December 06, 2013, 08:36:23 PM »
This is not an answer to the question that you asked, but I hope that you consider it.

Quote
The plan is to take the snowball I've been using for that ($650/mo) and max out my IRA (about $450/mo). Leaving me with the choice of opening an IRA in my wife's name for the remaining $200/mo, or paying down another loan.

The language that you used shows that you consider contributing to an IRA for you wife to be something you do with surplus money, after fully funding your own retirement account.  If this woman (who supports your family by raising your children) is your true partner in life, then why wouldn't you equally fund IRAs for both of you with any money that's available for that type of investment?

irrational

  • 5 O'Clock Shadow
  • *
  • Posts: 25
Re: When not to pre-pay loans?
« Reply #16 on: December 06, 2013, 09:03:47 PM »
This is not an answer to the question that you asked, but I hope that you consider it.

Quote
The plan is to take the snowball I've been using for that ($650/mo) and max out my IRA (about $450/mo). Leaving me with the choice of opening an IRA in my wife's name for the remaining $200/mo, or paying down another loan.

The language that you used shows that you consider contributing to an IRA for you wife to be something you do with surplus money, after fully funding your own retirement account.  If this woman (who supports your family by raising your children) is your true partner in life, then why wouldn't you equally fund IRAs for both of you with any money that's available for that type of investment?

Because the IRS doesn't let you have a joint account, lol.

They are both "ours". Plus, with communal property, they're both "ours" anyway. It's simply a issue of putting someone's name on the account to make the IRS happy.

When we retire, we'll split that money the same as we've split "my" paycheck. More a formality than anything else.

msilenus

  • Pencil Stache
  • ****
  • Posts: 517
Re: When not to pre-pay loans?
« Reply #17 on: December 06, 2013, 09:13:50 PM »
Your wife is a SAHM and deserves to have an IRA specifically for her.  She adds value to your family and therefore should have a retirement fund of her own, in her name, funded with FAMILY money.

I'm going to back the OP up on his decision to fund DW's Roth with leftover money.  Not having to split up every dollar you earn 50/50 is a basic function of marriage. 
As I understand things, IRAs are divisible in divorce.

If his wife has no interest in investing, then it's convenient and expedient to be working with your own accounts when managing the family's finances.  Even if you know about agent authorizations and have them set up, that only really helps you with trading unless you have full power of attorney, which is a pain.

fragglebock

  • 5 O'Clock Shadow
  • *
  • Posts: 24
Re: When not to pre-pay loans?
« Reply #18 on: December 06, 2013, 10:16:34 PM »
This is not an answer to the question that you asked, but I hope that you consider it.

Quote
The plan is to take the snowball I've been using for that ($650/mo) and max out my IRA (about $450/mo). Leaving me with the choice of opening an IRA in my wife's name for the remaining $200/mo, or paying down another loan.

The language that you used shows that you consider contributing to an IRA for you wife to be something you do with surplus money, after fully funding your own retirement account.  If this woman (who supports your family by raising your children) is your true partner in life, then why wouldn't you equally fund IRAs for both of you with any money that's available for that type of investment?

Because the IRS doesn't let you have a joint account, lol.

They are both "ours". Plus, with communal property, they're both "ours" anyway. It's simply a issue of putting someone's name on the account to make the IRS happy.

When we retire, we'll split that money the same as we've split "my" paycheck. More a formality than anything else.

It was more of a rhetorical question.

Still, equal ownership the retirement funds could have positive effects beyond tax benefits or satisfying IRS requirements. That's already implied by the nature of marriage and laws of communal property, but making it explicit is a simple way to honor your spouse's contribution to the family's success and well-being.  That is always something to consider when making financial decisions, especially when one spouse has a smaller (or no) income.

brewer12345

  • Handlebar Stache
  • *****
  • Posts: 1386
Re: When not to pre-pay loans?
« Reply #19 on: December 06, 2013, 10:28:23 PM »
Just throwing this out there...

Why all the fixation on the fact that student loans are not dismissable in bankruptcy? Seems rather anti-mustachian to actually plan for the what-ifs of a BK. If anything, wouldn't a mustachian life style tend to make the probability of needing to BK close to 0?

Sometimes things go badly no matter what you do.  Best to cover the downside as best you can.

dadof4

  • Stubble
  • **
  • Posts: 179
  • Age: 44
  • Location: Portland, OR
Re: When not to pre-pay loans?
« Reply #20 on: December 07, 2013, 01:08:28 AM »
I'd fund the IRA instead of pre-paying the loan. In all probability, it will come out in your favor.

I'm not sure where all the pre-nup/wife-asset-split comments are coming from. As you mentioned, the money belongs to both of you, regardless of whose name is on the account (both legally and morally).

aj_yooper

  • Handlebar Stache
  • *****
  • Posts: 1091
  • Age: 8
  • Location: Chicagoland
Re: When not to pre-pay loans?
« Reply #21 on: December 07, 2013, 04:53:58 AM »
Thanks All! This is some really good feedback. Exactly the type of thoughts I was looking for.

Very interesting regarding the idea of risk tolerance. I'd never thought of it that way, but yes, as a 30 year old I'm more interested in taking on more risk for potentionally higher returns.

2) Do you have PMI? If so then your effective mortgage rate is much higher. My PMI makes my effective mortgage rate go from 3.5% to 7%. If you do have it I can explain the math behind getting your effective rate

I'd never thought to question the effect of mortgage insurance on effective rates. We have an FHA loan, so it's technically not PMI... But, it does have some type of insurance attached to it. Also, unlike PMI, it's for the life of the loan (or until we refi as a non-FHA loan).

Regardless, I'm very curious now and would be interested in hearing how this changes things.
...It gets a little more complicated with the new FHA rules since it's doesn't go away without a refi but:

Figure how much the difference between what you currently owe and 78% of the current fair market value of your house is. This is how much you would need to pay down your mortgage to be able to refi without mortgage insurance. Divide your annual PMI by this number and add that percentage to your mortgage rate. This the the effective mortgage rate you are paying until you get rid of the PMI.

To help put real numbers behind this. I owe ~124K, my house is worth 136K

136k x 78% = 106k
124k-106k = 18k
My PMI is 54/month or 648/year
648/18000 = 3.6%
Plus my 3.5% mortgage rate = 7.1% effective

I can't itemize because my mortgage is small so I don't tax taxes into account on mine

Hope this helps

It is very important for you to put money into retirement accounts so that time will be on your side, not a limiting factor.  However, your PMI makes re-doing your mortgage a higher priority, IMO, as the effective interest rate is quite high.  I would find out what could be done to get into a lower mortgage, which means you need to get to 20% equity in the house as soon as possible.  Put your cash there.  That would be my first priority.  Then, the retirement accounts with a low cost provider, like a Vanguard. 

irrational

  • 5 O'Clock Shadow
  • *
  • Posts: 25
Re: When not to pre-pay loans?
« Reply #22 on: December 07, 2013, 08:02:23 AM »
I'm not sure where all the pre-nup/wife-asset-split comments are coming from. As you mentioned, the money belongs to both of you, regardless of whose name is on the account (both legally and morally).

Thank you!