Why pay off student loans?

[ifailedmcat]

This is a hypothetical question. If you have your loans locked <4%, why the rush to pay them off? Doesn't it make more sense financially to put the extra money in a brokerage account and invest for 4%+ gains? People already do this with their mortgages with rates at historical lows, can the same concept apply to low-interest student loans?

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[st2205]

I don't think people have had 4% in over a decade.

 

[ifailedmcat]

I don't think people have had 4% in over a decade.

Refinancing. People have been refinancing at around 4%. I finished residency 4 years ago and refinanced with a very average credit score. My loans are at 5% fixed.

 

[Plastikos]

Before LIBOR started going crazy the last couple months (either underlying Euro problems or the MM account Oct rules switch) it was pretty easy to get a variable in the low-mid 2% range.

Many on here and financial sites in general promote paying down loans asap as just part of the prescription, which is likely best for almost everyone as behaviorally, most will not invest that money they would have been paying to the loan.

Otoh, I am currently simply paying on time as scheduled, and everything else goes to the taxable account (after SEP/HSA maxing). You dont have to make the exact same % either as one is simple interest on a fixed term and thus fixed amount of total interest (look at truth in lending statement in docs) and the invested money will compound and can grow for decades or multigenerational if desired. Its really no contest as far as terminal wealth. At some point its nice to have no debt of course and probably after being satisfied with a nest egg of sorts I may pay off loans ahead of time...but seriously doubt it.

 

[InvestingDoc]

Just depends on the person if they want to pay off the debt at an interest rate <4% or not. My loans are <4% and I still plan on aggressively paying them off.

The theory I guess works if you assume that its a one or the other situation, meaning you spend all your capital on paying down loans or investing. Most people have retirement accounts or some types of investments which means that in the end you have a blended average of paying off your loans and some type of market returns. You may have an opportunity cost of spending money on the loans rather than an investment that MAY return 6% or higher, but in the end what if we are talking about a difference of 2-3%? If you pay off your loans over 5 or less years then the opportunity costs are limited to a relatively short period of time. Why not pay off the loans aggressively while maxing out retirement accounts and even putting a little post tax money into the market? My personal opinion is that if a new graduate one year after training is not able to do this then something is wrong and you need to take a hard look at your budget.

 

[ifailedmcat]

Before LIBOR started going crazy the last couple months (either underlying Euro problems or the MM account Oct rules switch) it was pretty easy to get a variable in the low-mid 2% range.

Many on here and financial sites in general promote paying down loans asap as just part of the prescription, which is likely best for almost everyone as behaviorally, most will not invest that money they would have been paying to the loan.

Otoh, I am currently simply paying on time as scheduled, and everything else goes to the taxable account (after SEP/HSA maxing). You dont have to make the exact same % either as one is simple interest on a fixed term and thus fixed amount of total interest (look at truth in lending statement in docs) and the invested money will compound and can grow for decades or multigenerational if desired. Its really no contest as far as terminal wealth. At some point its nice to have no debt of course and probably after being satisfied with a nest egg of sorts I may pay off loans ahead of time...but seriously doubt it.

Kudos to you. This is what I'm talking about. For terminal wealth this is the logical choice. If you have the discipline to invest your extra money in a taxable account it just makes more sense. I feel like student loans are made out to be these oppressive shackles and that paying them off is a sort of financial catharsis. I believe if anything, most doctors have the discipline to do this, but we are discouraged from doing so due to popular opinion.

 

[Plastikos]

Agree. If you have learned about finance and are early on in your investing career, there should be no catharsis in throwing money away. Let inflation do that work, why pay extra with the most valuable dollars you'll ever have for a one time hit. If you "get" these things I dont see why you cant be putting that money to work. If in practice it turns out you cant...then I find it hard to believe you'll suddenly put it to work against your loans as well, but it works for people so thats fine.

You can always turn around and use the taxable to pay off your loans if you change your mind, but theres no getting the extra loan money back, only month to month cash flow and only after its fully paid off of course.

 

[Plastikos]

Just depends on the person if they want to pay off the debt at an interest rate <4% or not. My loans are <4% and I still plan on aggressively paying them off.

The theory I guess works if you assume that its a one or the other situation, meaning you spend all your capital on paying down loans or investing. Most people have retirement accounts or some types of investments which means that in the end you have a blended average of paying off your loans and some type of market returns. You may have an opportunity cost of spending money on the loans rather than an investment that MAY return 6% or higher, but in the end what if we are talking about a difference of 2-3%? If you pay off your loans over 5 or less years then the opportunity costs are limited to a relatively short period of time. Why not pay off the loans aggressively while maxing out retirement accounts and even putting a little post tax money into the market? My personal opinion is that if a new graduate one year after training is not able to do this then something is wrong and you need to take a hard look at your budget.

It depends on how much you make, your loans, etc...whether or not its an all or nothing situation. Also, what you value of course, less debt versus more asset accumulation.

Its much more than the opportunity cost, and the return could be half or even less and still come out on top and the difference grows each and every year until you withdraw it. Its very simple to see just put the numbers in an investment calculator and let it rip. The earlier you start compounding the better, if you started later not only can you never get the compounding back, but your dollars are also worth less than they were 5 years ago as well. Which is where the double whammy comes in. You spent all this money and effort paying down aggressively in lieu of investing (for sake of argument only) in order to save yourself from having a discounted 25% (due to inflation of 3% for 10 years ) payment at some time in the future, all the while missing out on (historically) above inflation returns (median 21.8x, min 8.5x total return over 30 years). It doesnt sound so good when that "guaranteed return of 4, 6, x%" one time then goes on to lose 25% over the next 10 years, which it effectively does whether you account for it or not. In summary, its a permanent loss of compounding and opportunity that builds with each year.

Of course the choice is usually not binary, but the math is anything but subjective or unclear. You have differences in time and terms on your side. At some point if your nest egg has a nice start one may feel less pressure to add to it and change allocation % of course as priorities change. Its not that you cant do that, but you may not choose to even if you can.

I originally wanted to crush my loans as my primary goal and have them gone in 3 years, which was possible, but I wouldnt have made any retirement contributions at all, paid higher taxes, etc...and then couldnt see what I really gained from that in the long run, so I totally switched because the math made no sense. It would take one heck of a large windfall for me to ever pay too aggressively on loans and not invest any/all extra money. It doesnt make any less sense with 1 million dollars than it did at 10.

 

[QofQuimica]

It's a big "if" though. Everyone talks about how getting ahead financially is simple but not easy, and the reason why it's not easy is precisely because of the psychological factors. Meaning, many (maybe most?) people are NOT disciplined enough to be able to follow this type of plan. You've been out for four years; how many of your colleagues do you see still living paycheck to paycheck? I mean seriously, if someone can't "make ends meet" on a six figure salary, that doesn't mean there's something wrong with the salary! I guess I'm just trying to say, be careful that you're being honest with yourself about what you'll do with the money and not just trying to rationalize spending it on other things that won't help you achieve financial independence.

 

[Plastikos]

It's a big "if" though. Everyone talks about how getting ahead financially is simple but not easy, and the reason why it's not easy is precisely because of the psychological factors. Meaning, many (maybe most?) people are NOT disciplined enough to be able to follow this type of plan. You've been out for four years; how many of your colleagues do you see still living paycheck to paycheck? I mean seriously, if someone can't "make ends meet" on a six figure salary, that doesn't mean there's something wrong with the salary! I guess I'm just trying to say, be careful that you're being honest with yourself about what you'll do with the money and not just trying to rationalize spending it on other things that won't help you achieve financial independence.

I get this, but I find it odd that people always come back with this. I dont know what other people are doing with their money besides 1 or 2 people, and I generally dont try to interject myself into their business unless asked, though they sometimes do (go over their practice 401k setup, etc..). I dont know anyone living paycheck to paycheck, but again, dont concern myself with more than a couple very good friends. I do know one of my partners has a mountain of cash in a bank account for years and is "waiting for the market to be good again", but he is doing fine else wise.

What I dont understand about the comment is that if someone couldnt be trusted to invest their money and behavioral factors would lead them astray, how come they will pay down student loans instead? It makes no sense whatsoever. If there is something peculiar or unique about paying debt vs. investing what is it? The only thing I can tell is a misunderstanding of types of interest, terms, net worth, and long term goals. Once you remove the mystique of it all there shouldnt be any emotional payoff with the debt vs. invest issue, because you understand it and are just making a choice that lines up with your goals.

For some people thats to be debt free, for others its getting net worth to 0 and beyond fastest, and for others its a high terminal net worth and asset building.

I agree, most people are not that disciplined. However, those people arent knocking off their student loans in 2 years either. There is a selection bias to be sure. Most people would be better off learning how to budget, save for retirement in tax deferred space, and how their taxes work.

 

[QofQuimica]

I just know when we were late getting paid one time because there was some kind of delay in submitting our work hours, there were some docs going apes*** about how they were going to be late with their mortgage payments and all. Which is why I concluded they must be living paycheck to paycheck, because don't get me wrong: I wasn't happy about not getting paid on time either. But it was the principle of the thing (i.e., wanting to be paid on time for work completed), not because I was worried about not being able to pay my bills that month.

 

[Dr-Mo]

For me it was being debt free, it was emotionally a great move. My rates were low, I was at 2.75% and had about $150k graduating med school in 2005.

I attacked those loans aggressively and since then been investing every disposable dollar and I must say I don't regret it. I suppose if I knew for sure that I would get a guaranteed return on my investment in securities then I would take that bet and make minimum payments on my debt - but that isn't the case.

Being debt free means I can move anywhere I want, take any job I want, take time off whenever I want... that was important to me, so it's a bit personal, I realize that.

 

[Plastikos]

I just know when we were late getting paid one time because there was some kind of delay in submitting our work hours, there were some docs going apes*** about how they were going to be late with their mortgage payments and all. Which is why I concluded they must be living paycheck to paycheck, because don't get me wrong: I wasn't happy about not getting paid on time either. But it was the principle of the thing (i.e., wanting to be paid on time for work completed), not because I was worried about not being able to pay my bills that month.

Ok, now that you mention that it does remind of a story one of these friends told me about a similar situation. Except it was call money from the hospital where he is chief of that division, and of course call money is peanuts to your regular paycheck (at least in this case) and he said he could not believe the number of phone calls from people freaking out about not getting that as expected, as in a couple grand was going to throw their life into disarray. He couldnt believe it, especially since most of them were 10-20 years older than him. Its a bit shocking that it happens, but Im not at a hospital and in a small private practice so feel very isolated from whats going on with other docs.

Otoh, I am never sure when my paycheck is coming, if I or the boss am not there that day it may be a week or two before I get paid. My pay can also swing drastically, like a factor of 3, so theres always some float in the bank account so I never have to be concerned with what part of the month it is and when I get paid.

I guess there is a hidden upside to having crushing student loans right out of the gate, it forced me to come to grips with finance, educate myself, and have a plan.

 

[Gpan]

To me it's very simple. Paying off student loans is a sure thing. Meaning that if there are NO guarantee investment that can offer 6% in return then the interest rate you avoid by paying off loans is the better thing to do. Consider avoiding the student loan interest rate IS a form of investment, then you win by paying it off asap.

 

[Plastikos]

To me it's very simple. Paying off student loans is a sure thing. Meaning that if there are NO guarantee investment that can offer 6% in return then the interest rate you avoid by paying off loans is the better thing to do. Consider avoiding the student loan interest rate IS a form of investment, then you win by paying it off asap.

Sure, but the choice is not to pay off or not, nor as simple as always presented. Its to pay off in an accelerated fashion vs. investing the difference. The loans will be paid off, its just the timing in question.

You pay down aggressively for a one time gain of 6%, it then goes on to lose 25-50% over the next 10-20 years. Its not an isolated one time event, and then there are opportunity costs. The only thing guaranteed is that over the long term this is a loss.

Over a rolling 30 year period you historically have been guaranteed a return greater than that one time payoff. The minimum total return over that time is 850%, median 2100%. If you consider paying off student loans in missing out on this type of gain, paying aggressively is an inferior investment. Another way to look at it and simply see the total interest owed over the term. That is your maximum gain from paying it down asap, its finite and known. Put down your monthly extra payment in a calculator at a conservative rate of growth and see how long until cumulative gains eclipse that. It gets to keep growing even after that though, theres no specified maximum.

Most of the time people look at the choice over a too narrow time span, forget the future value of money and the effects of inflation on their payments and contributions. Todays dollars are worth more than in ten years and more time compounding better. From a net worth perspective, investing turns out better.

Obviously there are lots of other benefits to paying down loans which people have mentioned. Also, I am not here to try and convince people to do something or profess that one way is right or not. I dont really care what you do, you have your personal reasons and go for it. I really just want people to look at the choices more correctly, and not what I see all the time. "Guaranteed return", its a guaranteed savings of a known maximum amount, or "the market only gained 2% last year so it was the right choice" when unless you were retiring and drawing down that balance, I dont know how on earth that applies at all. This is a long term game, and should be thought of in that light. Just food for thought.

 

[bc65]

OP: That's a very good question.

I paid off a $100,000 3% mortgage around 2 years ago. I debated whether or not I should do this. Here's why I did it:

1. Paying off that 100k was like buying a treasury bond paying 3%. That's twice the interest rate that 30 year treasuries are paying. Now, I don't own any bonds. Most people would recommend bonds for someone my age,but I don't plan on having any bonds, for reasons I won't bother going into now. So for me, paying off that mortgage was in lieu of buying bonds. That was my rationalization.

To put it another way, anyone who has a portfolio that includes bonds paying 1-2%, while holding a mortgage or student loan costing 3%, is making a very foolish financial decision.

2. For anyone who has both investments and a loan or mortgage, the fact is that the loans are not just against the house, or for educational loans. Those loans are actually leveraging your entire life. Are you comfortable living your life that way?

If you are, how far will you take this? Will you keep that mortgage forever? Will you refinance it so that you can keep leveraging your investments? Now, a mortgage is a non-callable loan. Will you take it a step further and buy stocks on margin? Some people recommend doing this. I'm not comfortable with this. Investing on margin is what drives many investors, especially in real estate, into bankruptcy.

Some people will answer yes to these questions. I'm not willing to go that far. I felt very happy to have paid off all my student loans ,and I feel very happy to have paid off my mortgage, much happier than I thought I would be. I makes my monthly cash flow and planning a lot easier. While it may not be the absolutely best or most aggressive choice from a financial point of view, it's a luxury that I choose to "spend" my money on because it makes my life easier and makes me feel better.

 

[Plastikos]

OP: That's a very good question.

I paid off a $100,000 3% mortgage around 2 years ago. I debated whether or not I should do this. Here's why I did it:

1. Paying off that 100k was like buying a treasury bond paying 3%. That's twice the interest rate that 30 year treasuries are paying. Now, I don't own any bonds. Most people would recommend bonds for someone my age,but I don't plan on having any bonds, for reasons I won't bother going into now. So for me, paying off that mortgage was in lieu of buying bonds. That was my rationalization.

To put it another way, anyone who has a portfolio that includes bonds paying 1-2%, while holding a mortgage or student loan costing 3%, is making a very foolish financial decision.

2. For anyone who has both investments and a loan or mortgage, the fact is that the loans are not just against the house, or for educational loans. Those loans are actually leveraging your entire life. Are you comfortable living your life that way?

If you are, how far will you take this? Will you keep that mortgage forever? Will you refinance it so that you can keep leveraging your investments? Now, a mortgage is a non-callable loan. Will you take it a step further and buy stocks on margin? Some people recommend doing this. I'm not comfortable with this. Investing on margin is what drives many investors, especially in real estate, into bankruptcy.

Some people will answer yes to these questions. I'm not willing to go that far. I felt very happy to have paid off all my student loans ,and I feel very happy to have paid off my mortgage, much happier than I thought I would be. I makes my monthly cash flow and planning a lot easier. While it may not be the absolutely best or most aggressive choice from a financial point of view, it's a luxury that I choose to "spend" my money on because it makes my life easier and makes me feel better.

I think a lot of what goes wrong in these discussions has to do with several things. The first being personal comfort like you say, misrepresentations (calling mortgage a bond (unless you say negative), or over scarifying any leverage), and then the big one is where you are in your career. A new grad should probably prioritize retirement accounts over the mortgage prepayment, whereas if you've been out 5-10 years and have a good nest egg and even more stability it makes more sense to go after your mortgage if you so desire.

1. A fixed rate mortgage is an excellent currency/inflation hedge, some people look at it as a negative bond. You can think of it as a very expensive savings account I guess, or insurance for sure.

2. At some point isnt everything leveraged? Basically anything you do is based on the purchasing power/leverage that your profession allows you to earn as income. Without any leverage at all many would never have the earning potential to worry about any of these finer financial details. Taken to the extreme you were leaning to it doesnt make sense to get student loans as thats leverage. Having people wait until all these things are paid off to start investing will have a guaranteed negative effect on their terminal wealth level due to all the same issues that have been discussed previously.

At some point you have to view things through a probabilistic lens. Its highly unlikely I stay in one house a full 15 years, let alone 30. This is true for most of america as the average ownership length is something like 8 years. The transactional friction is heavy on real estate and can negate decent gains if done in short enough time period. There are certainly stark differences in leverage when discussing homes vs. investing, or say crazy things like naked shorting or trading options on margin. That is just a big straw man and false equivalence.

I wouldnt characterize someone holding bonds while having a mortgage as foolish, it really just depends on their reasoning. Bonds serve different purposes in different areas of life and the portfolio. I dont have any bonds for retirement but I hold about 45% of my invested securities in muni bonds, but the purpose is different and specific.

 

[bc65]

I think we probably agree overall, but as you suggest, different life stages and different semantics will result in some disagreements.

A fixed rate mortgage is an excellent currency/inflation hedge, some people look at it as a negative bond.

It's a negative bond, and paying it off will give you the same result as investing money at the same rate. However, paying off a loan gives a guaranteed up front payoff.

It's a hedge against inflation, but typically, stocks will go up more along with inflation to balance things out ( although not during the stagflation years of the 70's)

2. At some point isnt everything leveraged?

It certainly is. If you owe anyone money, that loan is financing every expense you make. It's a point that most people miss.

Taken to the extreme you were leaning to it doesnt make sense to get student loans as thats leverage.

Not really, because student loans are investments. To be clear, I'm not saying that no one should ever take out a mortgage. Most people need to borrow in order to buy a house, and it's worth the extra interest expense for them to get into the home 15 years earlier than if they had to pay all cash. However, I'm saying that once you can afford to pay off the mortgage, you should consider doing so. It won't always be the right thing to do, it will depend on the interest rate arbitrage between the cost of the loan and the expected yield on the investment

Having people wait until all these things are paid off to start investing will have a guaranteed negative effect on their terminal wealth level due to all the same issues that have been discussed previously.

I'm not exactly sure what you mean by this, but I'll say this: If you have a loan at 7%, as well as an investment that is compounding at 7% ( theoretical, and unlikely , but bear with me) your net result after 1 month, 1 year, or 20 years, will be exactly the same whether you use the money to invest, or you use the money to pay off the loan, so the only issue to be discussed when choosing between one or the other option ( ie using cash to pay off the loan or using it to invest ) is how likely the return on the investment will be, and how much of a premium you can expect from the investment, and how likely you are to get it, vs the guaranteed payoff inherent in paying off the loan.

Some people think that investing compounds and the loan doesn't, but they are failing to realize that if you have to pay 7% interest on the loan every year, that 7% is coming at the expense of the 7% growth of the investment which won't be compounding, because it went towards the loan.

At some point you have to view things through a probabilistic lens. Its highly unlikely I stay in one house a full 15 years, let alone 30.

I'll take you at your word, but that isn't the case for me. I waited until I was in my job for 7 years until I knew I would stay in the job and the area before I started looking for a house. I have been in my house for 15 years and will definitely be in this house until I die. One of my children will probably stay in it thereafter, as this is California and the real estate tax laws are such that staying in the house will keep the taxes low.

I dont have any bonds for retirement but I hold about 45% of my invested securities in muni bonds, but the purpose is different and specific.

Would you elaborate? I'm curious. Maybe I'll learn something.

But I'm saying that if your after tax yield on the bonds is less than the after tax cost of an outstanding loan, you would have been better off putting the money towards the loan. Of course, that also assumes that the lengths of the loan and the bonds are comparable.

 

[Plastikos]

I think we probably agree overall, but as you suggest, different life stages and different semantics will result in some disagreements.

I'm not exactly sure what you mean by this, but I'll say this: If you have a loan at 7%, as well as an investment that is compounding at 7% ( theoretical, and unlikely , but bear with me) your net result after 1 month, 1 year, or 20 years, will be exactly the same whether you use the money to invest, or you use the money to pay off the loan, so the only issue to be discussed when choosing between one or the other option ( ie using cash to pay off the loan or using it to invest ) is how likely the return on the investment will be, and how much of a premium you can expect from the investment, and how likely you are to get it, vs the guaranteed payoff inherent in paying off the loan.

That is not how the math works, not even close. A loan is simple interest, ie, it does not compound, whereas the market definitely does. Also loans have terms and end, usually and hopefully before you need to draw down your investments. You know up front the maximum you will pay in interest.

Lets use your hypothetical 7% loan with a 10 year term:

Total interest over the term is 39, 330.43
That 39k is the maximum you can guarantee save if you pay all 100k the first day. Lets say you over pay by 50%. This saves almost 4 years in payback and you only pay 23.5k in total interest for a savings of about 16k.
Savings-16k of interest.

Now lets invest that 500/month at the same rate (which isnt really fair tbh @ this rate):

Total balance: 86,993
Principal: 60,500
Interest: 26,493

Even your hypothetical over a very short and same time interval ends up investing being better. Of course these were chosen conditions, and they can differ. However, the big upside which I am trying to convey is you have no term limit. This money doesnt just stop compounding or even being contributed to when the loan is gone. It can continue to grow. So, lets not contribute to this account anymore but let it grow another 10 and 20 years with a more modest rate of 4.5% for the remainder.

Start: 86,993
+10 y @4.5%: 135,097. Now a full 48k is accrued interest, greater than the total owed in the original loan. Balance almost larger than total payoff as well.
+20 y @4.5%: 209, 800. Now you have almost earned more interest than the original loan+full interest.

So, we know up front day of signing the loan the max interest is 39k to pay back, but given our time frames and contribution consistency, thats probably not hard to overcome given a couple decades. Our real trick is time. You can change amounts, rates, or time frames and that will definitely change which is better over what time period, etc...but the general point remains. I would always refinance to lowest you can get, and if its 4 or greater I usually do put emphasis on paying those down.

Due to the above math, the interest doesnt even have to be the same, a slightly lower one will still more than make up for it if allowed to compound 20-30 years. Certainly if those arent your investing time frames and are not taking an actual long term view, this is not the right way to do it.

For the bond part it can be very useful on a risk adjusted return basis and does allow for a more consistent sustainable withdrawal rate as part of someones retirement plan. I think bonds have a lot more risk now than they have in a long time myself, but thats a separate thing. My muni bonds give me a nice tax equivalent yield in a relatively less volatile arena since Im in Cali as well.

 

[Plastikos]

I do agree it often comes down to stage in life, and have no illusions that I will think the same way about things then that I do now. Hasnt been true yet so I dont assume so in the future.

Also, I just find this stuff fun and someone has to take the opposite position.

 

[bc65]

, I just find this stuff fun and someone has to take the opposite position.

Yes, I agree , all for fun.

So in that spirit:

Your math on the loan vs investment is wrong, or more precisely, you're comparing the wrong things.

Remember, we are comparing two options: Either pay off a 100k loan at 7% with a lump sum of 100k, or instead paying the monthly payments on the loan while instead investing the 100k at 7%.
Both options will give you the exact same net worth at the end of any period of time. Run the numbers and see.

Here are several ways to demonstrate this:

As I wrote above, the easiest way to see this is to assume that you have a 100k loan at 7%, and an investment that will compound at 7%. Now, if you take the 100k and use it to pay off your loan all at once, your net worth will be zero.

Now look at two other alternative scenarios:

If instead you invest the money at 7%, then after one year you will owe 7k in interest, and you will have 7k in earnings. In order to pay off the interest you owe, you need to take the 7k you earned and pay the bank. You now don't have the money to compound. So you will end up with 100k invested with no income, and a 100k loan with no additional interest. The result is that your net worth is still zero.

Remember, money is fungible. If you don't pay the loan interest, it will compound at the same rate as the investment (ie negatively amortize). If you let the investment compound, but instead pay the interest from income, it doesn't matter, That same money would have compounded at the same 7% if you had invested it instead. It doesn't matter which pot the money comes from.

If you want to be more elaborate in comparing the two options, do this: Figure out what your monthly payments will be on a 30 year mortgage at say, 7%. Use an online calculator to get the monthly payment. Feels free to use any interest rate and any length of mortgage. Then take that monthly payment and plug it into an investment calculator, investing each month for the length of the loan, and see what you would have earned if you had instead invested that money at the same interest rate for the same period of time.

Now compare that number to what your would have if you had invested that same loan amount as a lump sum at the same interest rate, for the same length of time as the mortgage. Use the same investment calculator for that.

You will find that both alternatives give you the exact same total amount. In other words, the opportunity cost of the monthly loan payments, which is what counts, not the total payments, will exactly equal the total of the investment. In other words, if you paid off the loan as a lump sum, and then invested the monthly payments, it will give you the same result as if you had invested the lump sum, and then paid off the loan in monthly payments.

Regardless of how you look at it, either option will give you the same net worth over time.

The only thing that will give different results are if the loan and the investment had different interest rates. If they have the same interest rates, then either option will give the same net worth.

 

[bc65]

. A loan is simple interest, ie, it does not compound

I frequently see people say this. Let me add to my above post and elaborate on this misconception: All loans will compound if you don't pay them off , with the exception of some subsidized student loans during residency or school. Go ahead, try not paying your loan for a few years and see how much you owe. Trust me, it will compound. The banks call it negative amortization. It's the same thing. It will compound.

The only reason loans don't appear to compound is because you pay off the interest each month as it accrues. But the equivalent would be if you spent the interest on your investment each month instead of reinvesting it. Then it would not compound either.

Again, if you're comparing paying off your loan interest vs investing, at the same rate, they have to be the same. Each year, you owe interest, and earn interest. They exactly balance. Then you have to take additional principal from your assets to pay down the principal on the loan. So again, principal that would have been earning money as an investment is being transferred to the loan balance where, instead of earning interest, it will act to prevent you from owing interest. The net result is a wash.

 

[Plastikos]

I frequently see people say this. Let me add to my above post and elaborate on this misconception: All loans will compound if you don't pay them off , with the exception of some subsidized student loans during residency or school. Go ahead, try not paying your loan for a few years and see how much you owe. Trust me, it will compound. The banks call it negative amortization. It's the same thing. It will compound.

The only reason loans don't appear to compound is because you pay off the interest each month as it accrues. But the equivalent would be if you spent the interest on your investment each month instead of reinvesting it. Then it would not compound either.

Again, if you're comparing paying off your loan interest vs investing, at the same rate, they have to be the same. Each year, you owe interest, and earn interest. They exactly balance. Then you have to take additional principal from your assets to pay down the principal on the loan. So again, principal that would have been earning money as an investment is being transferred to the loan balance where, instead of earning interest, it will act to prevent you from owing interest. The net result is a wash.

Well of course. That is a completely fallacious argument and not one anyone has been discussing. If you dont pay your loans you probably arent investing. I literally did the math for you and showed you what you keep proposing as some kind of gospel, is not true. "People say that", because it is true. So if you are paying off the interest each month then it wont compound, great we agree, that is the starting point of the next part. Why do you keep saying that they "must be equal", it makes zero sense, and was illustrated for you. A debt does not perform the same as equity.

I get the feeling no matter what you will believe what you want to or concoct an even more outrageous scenario of doom that makes it fit your view. You are just plain wrong about the interest, about the differences when investing, and seem to be willfully so. There is no misconception except in your interpretation of how things work in reality.

I did run the numbers, and even from a more generous position to your view than your stated one and it came out badly. You try to make it work by making some wild scheme of paying for your interest with earned interest so it comes out to your chosen scenario, but again that is not the reality of either side of coin. You're trying to treat both an amortized loan and an investment as a CD, which theyre not. You can make any position make sense if you just change all the rules to fit your conclusions. The whole point of this was no one has to do anything with their investment until the time of their choosing, and was clearly spelled out as a prerequisite.

 

[Plastikos]

I frequently see people say this. Let me add to my above post and elaborate on this misconception: All loans will compound if you don't pay them off , with the exception of some subsidized student loans during residency or school. Go ahead, try not paying your loan for a few years and see how much you owe. Trust me, it will compound. The banks call it negative amortization. It's the same thing. It will compound.

The only reason loans don't appear to compound is because you pay off the interest each month as it accrues. But the equivalent would be if you spent the interest on your investment each month instead of reinvesting it. Then it would not compound either.

Again, if you're comparing paying off your loan interest vs investing, at the same rate, they have to be the same. Each year, you owe interest, and earn interest. They exactly balance. Then you have to take additional principal from your assets to pay down the principal on the loan. So again, principal that would have been earning money as an investment is being transferred to the loan balance where, instead of earning interest, it will act to prevent you from owing interest. The net result is a wash.

It does not balance, I showed you that in the example above. You have a limited, set amount of total interest on a loan which is known up front.

 

[bc65]

You try to make it work by making some wild scheme of paying for your interest with earned interest so it comes out to your chosen scenario, but again that is not the reality of either side of coin.

Look, I would like you to understand this because it might help you with your finances down the line, but I'm not so much concerned with you at this point as I am with OP.

OP asked an important question, and I don't want him to be misled because you don't get it. I think you are failing to understand that money is fungible. If you have to pay the interest on the loan, that money is coming at the expense of not investing that money. That's not a "wild scheme". That's an essential principle of investing: Money is fungible, and if you use the money for one thing, then you incur an opportunity cost somewhere else. The expense you incur by having the loan is eating up income you're getting from somewhere else. Your calculations completely ignored the opportunity costs of paying down the loan principal. My calculations below include that factor.

So with that in mind, here is the original question that we were discussing, with the hard numbers written out for you:

You have a $100,000 loan at 7%, and you have $100,000 in cash. The loan is for 30 years. The monthly payments are $665.30. ( Per the Bankrate mortgage calculator)

The question was, which of these two options is the best financial choice:

Invest the lump sum at the same interest rate as the loan, and keep paying the monthly loan payments,

or

pay off the loan with the lump sum, and invest the monthly payments instead.

Scenario #1 : You keep the loan, and use the $665.30 to make your monthly payments. You take the $100,000 and invest it as a lump sum at 7%, and let it compound for 30 years ( instead of using it to pay off the loan ).

At the end of 30 years, the loan is paid off, and the same investment calculator has the total of your investments at $761,225.50.

Scenario #2 : You pay off the loan with the $100,000 as a lump sum, and then invest the monthly payments that you no longer have to make at 7%. ( i.e. monthly payments of $665.30 at 7%, compounding annually for 30 years ). At the end of 30 years you will have investments worth $759,225.50 ( per the investment calculator at investor.gov )

So a difference of exactly $2,000 between the two scenarios, or a difference of 0.2%, which is probably due to the mortgage payment being rounded down by a penny or two. (In the past with other calculators the numbers came out exactly the same, to the penny.)

So essentially no difference between the two scenarios we were comparing. As you can see, whether you call the loan compounding or not compounding, if you compare the two options, you end up with the same net worth.

Consider this: You have the $100,000 in a bond fund paying 7%. The interest posts on December 31st, at which time you look at your accounts. Now the account has $107,000. If you leave that money in the account, then next year you will get even more interest, and that money will grow faster and faster.

But there's a problem, because you also get a bill from the bank, telling you that you owe $7,000 in interest, plus $10,000 in principal. Now, where are you going to get the money from to pay the bank? Well, one option is that you can take the $7,000 in interest that you earned on this account and give that to the bank for the interest payment, and then take $10,000 out of the principal and use that to pay off the principal that you owe. Now you're left with only $90,000 in your investment account, and a loan on which you owe $90,000.

Now I hear you say, "there you go again with that 'wild scheme'. Why, I can use any money from somewhere else to pay off that bill from the bank, while I let this account compound and grow". So now I will ask you, where will you get that money? All your money is either spent or saved. So the bill from the bank has to come from money that is either

a. already saved
or
b. would have been saved.

In either case, it will decrease your savings by the amount you owe the bank, and the money you pay the bank will no longer compound.

That is why there's no advantage to keeping the loan and investing instead. It's because whatever money you use to pay the bank, it's coming at the expense of other money that won't be yours to grow or 'compound'.

Remember, money is fungible, and money used for any purpose incurs opportunity costs.



Now, to get back to OP's scenario, since we have eliminated the red herring of "compounding" , you simply have to decide how much risk you want to take with your money. I can tell you right now that if guaranteed US Treasury Bonds were available today paying 4%, or even 3%, that every single investor on Wall Street would be snapping them up as fast as they could, and selling all their stocks in order to do so. So I think that based on that, most people would tell you that your money should go towards paying off that loan, because paying off that loan is giving you the equivalent of a guaranteed bond paying you the interest rate that your loan is set at. Now, if your interest rate on the loan is less than 3%, you might consider keeping the loan and investing instead, but if you do that, make sure that you don't own bonds.

I think this is clear enough for anyone who wants to understand this question. I'll let you have the last word.

 

[ISuckAtLife]

You are right, but your scenario is not practical at all. Most people who choose to invest rather than pay off loans do so after refinancing or switching to repaye. When there is a typical difference between the loans and the long term investment returns (~3% per year), the net worth difference at the end is dramatically in favor of investing. Compounding is not a red herring either. Even a small difference in the growth rate (i.e. loans at 3% versus investing at 4%) compounding over 30 years will make a huge difference.

 

[Plastikos]

That is not the scenario, and it was not the question. This is your sterilized situation to make your own point, which you dont do very well. There is no lump sum nor an either or situation. We all for the most part have enough money to do both or preferentially one over the other if we so choose.

In your scenario you started with an already paid month to get the ending amounts similar, otherwise its off another 5k.

Also, you are completely ignoring, even given your cherry picked unrealistic scenario, "its the same" situation the make up of those ending totals. So, per your situation and numbers:

Lump Sum: 761k; 100k principal and 661k interest.

Loan Paid: 754k; 239.5k principal and 514k interest.

That is, in order to get you to the "same outcome" you paid more than twice as much, and per your own reasoning failed to account for the opportunity cost of the extra 139.5k as well. This also ignores inflation, time value of money and liquidity issues. Again, you paid more for less. The lump sum saved 139.5k. Those payments at year 30 are done with money that is historically going to be at 40% of its nominal value due to inflation. Its time arbitrage, thats really the only thing we have on our side, and a good income.

When you borrow money it has a cost. That cost, is the main issue and hurdle rate that needs to be overcome not ending amount or other straw men. Will your ultimate interest/dividends/etc...end up more than that cost at your specified time, thats it. For those that espouse to throw everything at every single debt first before any investing the outcomes are much worse of course, because you then start at whatever number of years later at 0, lost productivity is gone forever. I dont know may people that say that, but some do.

Compounding is not a red herring, as long as you believe nonsense like that, there is no common ground to have a reasonable discussion.

 

[bc65]

When there is a typical difference between the loans and the long term investment returns (~3% per year), the net worth difference at the end is dramatically in favor of investing.

OP was asking why people choose to pay off loans at 3 or 4% rather than invest at 7-10%.

The reason is not because they don't realize that 3% is lower than 10%. . It's because they prefer a guaranteed 3% or 4%, vs a volatile possible 7-10%, with a possibility of a 60% market drop at any time, like we had in 2007. That guarantee is worth a lot.

So by all means, invest for the long term, and invest in riskier investments if you think you can resist selling when the market drops. I am invested about 98% in index funds, but I know that I can handle the consequences. Nonetheless, I paid off my 3% mortgage despite the higher yield of equities, because it made my cash flow better and because I liked getting that immediate guaranteed return. Look at all the professional investors buying bonds that yield 1.5%, or the European bonds paying negative interest. Those guys would jump at the chance to dump all their money into a 3% bond, which is what paying off your loan will give you. But OP's question was, why would anyone pay off their loan at 3% when they can earn 7 or 10% in the market, and that's why. Because getting a sure thing is worth a lower rate. That's precisely why bonds yield less than equities over the long term.

Compounding is not a red herring either. Even a small difference in the growth rate (i.e. loans at 3% versus investing at 4%) compounding over 30 years will make a huge difference.

I wasn't dismissing the value of compounding. What I was trying to explain in my posts is that the apparent lack of compounding in loans is a red herring if you are making payments on a loan, because the payments that you make are taking money away from your investments. So even though your payments prevent the loan amount from compounding, that exact same amount of money is taken out of your investments, so you lose the compounding that you would have gotten had you paid off the loan. The effect on your net worth is the same.

 

[ISuckAtLife]

OP was asking why people choose to pay off loans at 3 or 4% rather than invest at 7-10%.

The reason is not because they don't realize that 3% is lower than 10%. . It's because they prefer a guaranteed 3% or 4%, vs a volatile possible 7-10%, with a possibility of a 60% market drop at any time, like we had in 2007. That guarantee is worth a lot.

So by all means, invest for the long term, and invest in riskier investments if you think you can resist selling when the market drops. I am invested about 98% in index funds, but I know that I can handle the consequences. Nonetheless, I paid off my 3% mortgage despite the higher yield of equities, because it made my cash flow better and because I liked getting that immediate guaranteed return. Look at all the professional investors buying bonds that yield 1.5%, or the European bonds paying negative interest. Those guys would jump at the chance to dump all their money into a 3% bond, which is what paying off your loan will give you. But OP's question was, why would anyone pay off their loan at 3% when they can earn 7 or 10% in the market, and that's why. Because getting a sure thing is worth a lower rate. That's precisely why bonds yield less than equities over the long term.

Right, but people tend to overvalue the guarantee because they don't understand how dramatic the difference would be long term. The risk involved in holding an index over 30 years is low. To overpay loans as a hedge against this low risk is often overly conservative. Many people who are irrationally debt averse also don't bother making 401k, roth, or HSA contributions so that they can get rid of the debt sooner...that is also a huge mistake.

I wasn't dismissing the value of compounding. What I was trying to explain in my posts is that the apparent lack of compounding in loans is a red herring if you are making payments on a loan, because the payments that you make are taking money away from your investments. So even though your payments prevent the loan amount from compounding, that exact same amount of money is taken out of your investments, so you lose the compounding that you would have gotten had you paid off the loan. The effect on your net worth is the same.

This is simply not true. You originally stated that somehow loans would start to capitalize and you would eventually realize it. That is simply wrong. Even the monthly payments often do not cover the interest under the most common payments plans, like IBR, paye, or repaye. The payments often have nothing to do with the interest that accumulates; they are based on income. Some people (including myself) have had $0 payments. If the payments do not cover the interest, the uncovered interest does not capitalize.

 

[bc65]

Even the monthly payments often do not cover the interest under the most common payments plans, like IBR, paye, or repaye. The payments often have nothing to do with the interest that accumulates; they are based on income. Some people (including myself) have had $0 payments.

No one was talking about subsidized loans. Sure, if you have a loan at zero % interest, and someone else is paying the interest, don't pay it off.
I was referring to a regular, unsubsidized loan. OP never mentioned IBR, REPAYE, etc.

But you are correct. At one time, at least, the effective rate on some of those loans was as low as 1.5% with the subsidies and the forgiveness at the end. At 1.5%, I would keep the loan. At 3%, you can go either way. As I said before, at 3%, I paid off my mortgage.

Right, but people tend to overvalue the guarantee because they don't understand how dramatic the difference would be long term. The risk involved in holding an index over 30 years is low. To overpay loans as a hedge against this low risk is often overly conservative.

Obviously I agree with your sentiment, since I'm all in index funds, but that wasn't OPs question. The question was "why do some people pay off the loans" not "why do some people keep the loans they invest instead".

Also, I disagree that "people tend to overvalue the guarantee". If that were the case, you wouldn't have major investors and investment banks buying bonds. Granted, they have different goals and timelines, but I think all those guys know what they are doing.

You originally stated that somehow loans would start to capitalize and you would eventually realize it.

I may not have been clear here. I was trying to say that there's nothing inherently different about loans compared to investments when it comes to compounding. A loan generally requires you to pay the interest in full as it accumulates, so it generally won't compound. However, if you don't pay the interest, it will capitalize each year and compound ( ie negatively amortize) . On the other hand, if you spend the interest from an investment each year, it won't compound. In other words, both will compound if you let them, and neither will compound if you take away the interest.

 

[bc65]

Lump Sum: 761k; 100k principal and 661k interest.

Loan Paid: 754k; 239.5k principal and 514k interest.

At the end of 30 years, the net worth with either scenario is the same, as I clearly demonstrated. That's all that matters. Net worth. The same.

( I don't know what these numbers mean. How can I pay 239 k of principal on a 100k loan?)

. Those payments at year 30 are done with money that is historically going to be at 40% of its nominal value due to inflation.

Guess what? At the end of 30 years, inflation will deflate your payments as well as you investments. At the end of 30 years, both options will yield identical amounts, whether you calculate as nominal or real.

Its time arbitrage, thats really the only thing we have on our side, and a good income.

I agree, well put. Although we have less time as doctors, due to school and residency, research and fellowships.

Will your ultimate interest/dividends/etc...end up more than that cost at your specified time, thats it. For those that espouse to throw everything at every single debt first before any investing the outcomes are much worse of course, because you then start at whatever number of years later at 0, lost productivity is gone forever.

This is where you go wrong. If you pay off the loan, you don't lose out on ultimate net worth, because you're paying back principal that wasn't yours, and you're saving on the interest payments you won't have to make. So after 1, 5, 10, or 30 years, your net worth will be the same. Run the numbers and see. I showed you that the numbers work for one payment schedule. If you think I'm wrong, try it again with other options, and see what result you get.

This is true whether you pay off the entire loan, or just some of it. It's true whether you pay just interest, or if you pay some principal, or all of it. At any point in time, the net worth will be the same. The only variable will be the respective interest rates.

The numbers don't lie.

Compounding is not a red herring, as long as you believe nonsense like that, there is no common ground to have a reasonable discussion.

That's not what I said. I was referring to your contention that the loan doesn't compound as a red herring. (see my reply to the poster above) The loan compounds if you don't pay the interest, and an investment won't compound if you spend the interest. They behave the same way. There's no special "compounding" feature that applies to investments but not loans. I thought that my meaning was pretty clear.

 

[ISuckAtLife]

No one was talking about subsidized loans. Sure, if you have a loan at zero % interest, and someone else is paying the interest, don't pay it off.
I was referring to a regular, unsubsidized loan. OP never mentioned IBR, REPAYE, etc.

I was not talking about subsidized loans. The same rules apply for unsubsidized loans under any of those payment plans. The payments do not cover the full interest and the remainining interest does not capitalize, even for unsubsidized loans under any of the mentioned plans. People don't need to mention these plans...it is assumed since nearly everyone has a loan under IBR, paye, or repaye if it's from med school unless they refinanced.

I may not have been clear here. I was trying to say that there's nothing inherently different about loans compared to investments when it comes to compounding. A loan generally requires you to pay the interest in full as it accumulates, so it generally won't compound. However, if you don't pay the interest, it will capitalize each year and compound ( ie negatively amortize) . On the other hand, if you spend the interest from an investment each year, it won't compound. In other words, both will compound if you let them, and neither will compound if you take away the interest.

You were very clear in what you said. You're wrong.

Both the unsubsidized and subsidized loans that the majority of people have do not require you to pay the interest in full as it accumulates. If you do not pay some or all of the interest, it does not capitalize/compound. It is as simple as that.

 

[bc65]

You were very clear in what you said. You're wrong.

I am addressing a generic question about how loans work vs investments. I'm not talking about student loans at all. I'm not talking about special payment plans. As I very clearly wrote above, I'm not talking about IBR, PAYE, REPAYE, etc. I'm not talking about a specific type of subsidized loan. I'm talking about regular loans that you would get from a bank. Like a mortgage. Like a car loan. The kind of loans adults get.

 

[ISuckAtLife]

I am addressing a generic question about how loans work vs investments. I'm not talking about student loans at all. I'm not talking about special payment plans. As I very clearly wrote above, I'm not talking about IBR, PAYE, REPAYE, etc. I'm not talking about a specific type of subsidized loan. I'm talking about regular loans that you would get from a bank. Like a mortgage. Like a car loan. The kind of loans adults get.

Seems like you have no interest in actually addressing the common, practical question people here have with actionable advice.

And even in your "grown ups" example, mortgage interest is deductible and most of us will probably be in the highest tax bracket of our lives while paying said interest so the effective interest rate is significantly lower.

Paying off non-callable debt that is deductible with an effective interest rate below inflation (like you did) doesn't make sense mathematically. It's just an emotional decision. There's nothing wrong with that per se...some people have low debt tolerance. But it should be clear that it probably loses by a wide margin over the long term. It really is as simple as that.

 

[Plastikos]

( I don't know what these numbers mean. How can I pay 239 k of principal on a 100k loan?)

That means that if you chose to pay off the loan asap with the 100k, and took the resulting cash flow and invested it over the next 30 years instead, you would have put in 239.5k worth of payments over time to reach a similar number the 100k would have resulted in by itself in a one time fashion. This example was tailor made to look as good as possible. Otoh, a real example of 10 year debt term and 30 years of investing does not come out even close, and thats much closer to reality and where it makes a difference over time in true net worth.

However, neither of those are close to reality as we are already paying our loans, and the OP was asking why pay extra instead of investing? In that more realistic approach the max gain is the cost of the loan, nothing more. The upside to investing is far greater than that, and its hard to find a situation where that isnt true. I wouldnt hold any debt or stretch it out over 4%, Im not saying leverage it to the hilt, but the math is super clear.

As for inflation, thats why its better to get the most use out of your earlier money, and the most use is compounding for the future for the longest time interval possible. Not paying ahead on a loan to save yourself a 30-50% off payment in the future. In your example it only "cost" 100k to reach that final number where it cost 239.5k with averaged inflation and would cost 761k as a balloon buy after 30 years. Your earliest dollars are worth more than your later ones, and should be treated accordingly.

 

[bc65]

Seems like you have no interest in actually addressing the common, practical question people here have with actionable advice.

And even in your "grown ups" example, mortgage interest is deductible and most of us will probably be in the highest tax bracket of our lives while paying said interest so the effective interest rate is significantly lower.

Paying off non-callable debt that is deductible with an effective interest rate below inflation (like you did) doesn't make sense mathematically. It's just an emotional decision. There's nothing wrong with that per se...some people have low debt tolerance. But it should be clear that it probably loses by a wide margin over the long term. It really is as simple as that.

I did give actionable advice. At 4% effective interest I would pay it off. At less than 3% I wouldn't. In between is a personal call.
For student loans, you can refinance or get forgiven at 10 or 20 years which requires individual evaluation.

I agree with you completely, as I wrote in my first post, that my heart ruled this decision more than my head.

But at my income level, the amount left was fairly trivial. And I ask again, if leveraging is such a good deal, should I take out another mortgage? I think not. But some might.

At my income, there's no mortgage deduction. AMT tax.


Sent from my iPhone using SDN mobile

 

[bc65]

However, neither of those are close to reality as we are already paying our loans, and the OP was asking why pay extra instead of investing? In that more realistic approach the max gain is the cost of the loan, nothing more. The upside to investing is far greater than that, and its hard to find a situation where that isnt true. I wouldnt hold any debt or stretch it out over 4%

OP was asking a theoretical question, not what he should do, but why some people pay off the loans.

While leveraging stock market investments with a mortgage ( which is non-callable, unlike buying on margin ) makes sense on paper, I would avoid all kinds of leverage and would advise against it. Over time, the market returns 7% nominal, so in theory, everyone should refinance their mortgage again and again, especially now with historically low interest rates. But I would never dream of doing that. Will you refinance your home to invest when you get ready to retire? Not me. Leverage is what gets a lot of people into trouble. But different people take their risks in different places.

I agree that in the current environment, a loan of 4% or more should be paid off. Below 3% I would keep.

But that still makes me wonder why anyone would buy bonds at 1 % or 2% when the total market index or S&P 500 pays a dividend of 1.89%. And if someone has a mortgage at 3%, why own bonds at 1 or 2%? You're borrowing money at 3% to get a return of 2%.

As far as the numbers above are concerned, I give up. I understand what you're saying above, but I don't think it's relevant. Perhaps I could explain it better to you in person, but I'm quite sure that the alleged lack of compounding has no effect on the question of paying off a loan vs investing, but apparently I haven't been able to explain it to you, so let's agree to disagree. Otherwise, we'll just go around with the same argument again.

 

[Plastikos]

You personally hate leverage. I totally get that, and you wouldnt do anything you deem risky, I also get that and its totally your right of course.

I own muni bonds, but their tax equivalent yield is 7-9% and they are part of my taxable account, I also agree bonds at 1-2% arent much to have in your account and at this juncture may actually be the risky side of your portfolio or at least not the safe haven people have come to expect. Who knows, we may have low rates forever like Japan, I dont think so, though I dont believe we'll see the 80-00s rates anytime soon. Every time is indeed different. The best time to buy bonds is in a rising rate/inflation environment.

The difference in our example is that term length was one of the most important caveats to the scenario winning out. Of course if the terms and rates are exactly the same, the nominal amounts are similar from an absolute value perspective. Yet we control the term on both sides of the equation and may do so to our long term advantage. You have to have a very long term view on it though.

 

[ifailedmcat]

Hi everyone, OP here, thank you for all of the insightful posts. As you may have guessed, I have already made up my mind prior to creating this thread. I was just making sure I wasn't overlooking something important in my reasoning.

bc65, I agree with your math. I agree that a 100k loan at 7% over 20 years should be equivalent to a 100k lump sum cash invested at 7% over 20 years.

I have 200k in student loans at 5% with 17 years left of repayment and a mortgage of 350k at 4% with 28 years left (just bought the house 2 years ago). I am about to make partner this year and expect a roughly 50k increase in salary. So I am in a position to make extra payments to either of my loans..

I think fundamentally, I definitely differ from you. I am not debt averse at all. I am totally okay with more risk. I am completely okay with maintaining a mortage and student loan debt. I already max 401k, IRA, FSA and dep care accounts. I actually already prepaid 2 extra months towards my student loans (2 years ago) and I still regret doing this.

I get your reasoning and appreciate the analogy of buying a bond with a guaranteed rate. I know 7% is not guaranteed but it my mind it is close enough. I have basically 90+% equity with no bonds in my portfolio.

 

[Gpan]

Sure, but the choice is not to pay off or not, nor as simple as always presented. Its to pay off in an accelerated fashion vs. investing the difference. The loans will be paid off, its just the timing in question.

You pay down aggressively for a one time gain of 6%, it then goes on to lose 25-50% over the next 10-20 years. Its not an isolated one time event, and then there are opportunity costs. The only thing guaranteed is that over the long term this is a loss.

Over a rolling 30 year period you historically have been guaranteed a return greater than that one time payoff. The minimum total return over that time is 850%, median 2100%. If you consider paying off student loans in missing out on this type of gain, paying aggressively is an inferior investment. Another way to look at it and simply see the total interest owed over the term. That is your maximum gain from paying it down asap, its finite and known. Put down your monthly extra payment in a calculator at a conservative rate of growth and see how long until cumulative gains eclipse that. It gets to keep growing even after that though, theres no specified maximum.

Most of the time people look at the choice over a too narrow time span, forget the future value of money and the effects of inflation on their payments and contributions. Todays dollars are worth more than in ten years and more time compounding better. From a net worth perspective, investing turns out better.

Obviously there are lots of other benefits to paying down loans which people have mentioned. Also, I am not here to try and convince people to do something or profess that one way is right or not. I dont really care what you do, you have your personal reasons and go for it. I really just want people to look at the choices more correctly, and not what I see all the time. "Guaranteed return", its a guaranteed savings of a known maximum amount, or "the market only gained 2% last year so it was the right choice" when unless you were retiring and drawing down that balance, I dont know how on earth that applies at all. This is a long term game, and should be thought of in that light. Just food for thought.

I appreciate your input. I see a few points that could make your statement not applicable.

1- For Student loans, I have never seen or heard of a 30 YEARS payoff term. Usually it's 10 years, or if you refinance its 12, 10, 8 , 5 or less. I have never seen 30 YEARS. Correct me if I'm wrong on this.
2. The choice is not whether we should pay off student loans or not. The point is to pay off AS FAST AS POSSIBLE to minimize the damage of interest. Basically fighting against TIME. SO if you can pay off the loan ASAP, the gain is NOT just ONE TIME GAIN. It's a GAIN FROM preventable YEARS (12, 10, 8, ect. years) of COMPOUND INTEREST. Would you agree on this?
3- I totally agree with you that Today dollars are worth more than in ten years and more time compounding better. HOWEVER, like my original point, there is NO GUARANTEE GAIN in investing.

Please share your thoughts on my points above. Thanks

 

[Plastikos]

I appreciate your input. I see a few points that could make your statement not applicable.

1- For Student loans, I have never seen or heard of a 30 YEARS payoff term. Usually it's 10 years, or if you refinance its 12, 10, 8 , 5 or less. I have never seen 30 YEARS. Correct me if I'm wrong on this.
2. The choice is not whether we should pay off student loans or not. The point is to pay off AS FAST AS POSSIBLE to minimize the damage of interest. Basically fighting against TIME. SO if you can pay off the loan ASAP, the gain is NOT just ONE TIME GAIN. It's a GAIN FROM preventable YEARS (12, 10, 8, ect. years) of COMPOUND INTEREST. Would you agree on this?
3- I totally agree with you that Today dollars are worth more than in ten years and more time compounding better. HOWEVER, like my original point, there is NO GUARANTEE GAIN in investing.

Please share your thoughts on my points above. Thanks

1-This was exactly my point. As I said in the post above yours, making the term artificially long makes it look comparable. Having a shorter term like 10 years and and much longer investing time frame like 30 is what makes it work. However, yes you can find student loan repayment schedules that are 25-30 years, but that doesnt make them a good idea.
2-Yes, this is the choice. Why would you fight against time when time is devaluing the debt you owe? The gain is still limited to the amount of interest owed/cost. It is fixed, you cannot gain more than that. There is NO COMPOUND INTEREST. Words have meaning, including these. Look them up and see how its structured. They are literally absolutely different equations. Its like a pts saying vaccines cause autism.
3-Theres no guarantee outside of death. We can only go on what we know and probabilities. The probability that money invested today in an index will be worth more in 30 years is very high. If you understand inflation than why the rush to paying down the loans ASAP. We should remember the point of investing is to preserve purchasing power in the future.

For example, off the top of my head from memory of this thread it would look like this.

100k student loan, entering repayment @7%, 10y term
The TOTAL amount of interest owed if paid as scheduled is 39,330. Thats the total possible to be avoided. You cannot do better than that. This is true of any loan. This number is always disclosed up front and should be thought of and indeed is labeled as the "cost".

Otoh, if you invested it and let it ride 20, 30 years you will eventually have multiples of that total cost/interest on the loan. I did this exact calculation in post #19 with conservative numbers. Punch your assumptions into a calculator. For fun lets do a 500/month that could have been paid to loan and instead invest it, but only up until the term is over and then let it ride, never contributing after the loan term is up.

After 10 y
Loan interest paid/10y=39,330.
Invest account (@4%) 73.5k, (60/13.5)

20y
Inv (@4%)=108.8k

30y
Inv (@4%)=161.1k

This is with a nearly half the interest rate and never contributing more than you would have to the loan. With most people taking advantage of low interest rates (my loans are at 3.06%) and even with the market at ATH, the odds are actually quite stacked in favor of investing in real life. Even better if you have a bear market at the beginning.

Hopefully in real life you can contribute more and dont stop because your loans are gone but rather increase. That doesnt mean you shouldnt pay off your loans or mortgage if you value those trade offs, which there are many. However, there is no need to make things up to justify your position that make no sense, which seems to happen all the time.

 

[ISuckAtLife]

Out of curiosity...

For those of you who favor paying off loans before investing, do you also favor extra loan payments over contributing to 401k, IRA, and/or HSA?

 

[bc65]

Out of curiosity...

For those of you who favor paying off loans before investing, do you also favor extra loan payments over contributing to 401k, IRA, and/or HSA?

It depends.

In general, I would max out my retirement accounts first because the tax savings will far outweigh any benefit from paying off the loans early, especially with loans at 5% or less.

You want to fund the retirement accounts because they are tax advantaged. This is a long topic in itself, but you either pay taxes now with a Roth because your taxes are lower now ( eg 5 or 10%) than they will be when you retire ( eg 20-24%), or you defer taxes in a traditional 401k because your taxes are higher now as an attending ( eg 39%) but will be lower ( 20-24%) in retirement. Plus, you put the money in at your marginal rate, but withdraw it at your effective (blended) rate which is almost always lower. There are exceptions, but that's why you use tax advantaged accounts.

So you generally want to use those accounts to get the match ( if employed) and the tax benefit. But if you have credit card debt at 24%, for example, you should probably pay that off first.

I get your reasoning and appreciate the analogy of buying a bond with a guaranteed rate. I know 7% is not guaranteed but it my mind it is close enough. I have basically 90+% equity with no bonds in my portfolio.

That's fine. Go for it. I still think you should pay off the 5% loan, but I can't argue with your logic. Just remember, when the market drops, buy, don't sell. You should be fine as long as you avoid individual stocks.

As for your specific situation, you should be able to refinance your loans at a lower rate, at least the 5% loan. Have you tried that? Also make sure you looked into all the relevant repayment plans.

I own muni bonds, but their tax equivalent yield is 7-9%

How did you get bonds paying that much, 3.5-4.5%? You must have them a long time. I don't trust California municipal bonds. Some have defaulted. If I were to buy bonds, I would do if for the guarantee, i.e. treasuries.

. The choice is not whether we should pay off student loans or not. The point is to pay off AS FAST AS POSSIBLE to minimize the damage of interest. Basically fighting against TIME.

Right, but the overall issue here is that time and inflation cut both ways. Time increases the total amount of interest you pay on the loan. Time increases the value of the investment. So you want to do what maximizes the interest rate in your favor.

Inflation decreases the value of the investments, but it also decreases the value of the loan. It balances out.

As you point out, paying off the loan is a sure thing. The investment is not. Strictly speaking, the investment will give you the best rate of return long term. However, as I mentioned before, most people will tell you to pay off 4% or more as soon as is reasonable. Most might keep a loan of less than 3%. But don't buy bonds paying less than your loans; pay off the loans instead of buying bonds.

It's a GAIN FROM preventable YEARS (12, 10, 8, ect. years) of COMPOUND INTEREST. Would you agree on this?

This is correct. You can't ignore gained opportunity cost of paying off the loan. By paying off the loan, you save the interest, which you can then invest, and it will then compound. While the interest on a loan won't compound if you pay it off as it accrues, you will have that much less money to invest, so you lose the compounding of your net worth.

The big issue is just the difference in interest between investing and paying off the loan. As you point out, you get a higher return by investing, but it's not guaranteed. This is the basis upon which all investing works.
In general, in order to get a higher return you have to take more risk. You need to decide for yourself how much risk you're willing to take, and how much of a return you need in return for greater risk.
Unfortunately, many, if not most, people find out too late that they have a lower tolerance for risk than they once thought.

How will you feel about this discussion when the stock market loses half its value, like it did in 2000? How will you feel when it loses 60% of its value, like it did in 2007? What if it loses 70% of it's value 3 years from now? You will wish that you had paid off that loan instead. Think about it, and be sure you're comfortable with your decision now, and that you will be comfortable with your decision when the next big market drop comes.

Too many people panic and sell at the bottom after a market drop. You have to be confident that you won't do that. That's a vote in favor of paying off your loans. I have been through several big market crashes. I know that I can ride through them and can keep investing. Most people can't. You won't know how you will react until you have been there. Keep that in mind.


Regarding the above discussion about loans vs investments:

An investment is just the other side of a loan.

For those who still don't get it, try looking at it this way:
You invest $100,000 for 10 years. The investment pays you 7% a year for 10 years.
Your investment is someone else's loan: 7% for 10 years.
Your investment is someone else's loan. Your loan is someone else's investment. They balance out.

If you lend yourself money and charge yourself interest you will come out even.
If you lend one person money at a given rate and borrow it back from someone else at the same rate you will break even.
If your investment is a loan or if it's "an investment" it comes out the same.

The interest you pay on a loan doesn't compound against you if you pay it. But the interest that you pay is no longer yours so it can't compound in your favor. That's why it balances out.

If you get paid interest from a bond or a loan or from mutual fund dividends, it's up to you to re-invest it. It doesn't magically compound. There's a box you check when you open the account, where you choose between getting a check for dividends and interest, or to automatically re-invest. Compounding occurs when you re-invest those interest payments. If you re-invest, then it will compound. If you don't re-invest, it won't compound.

So in the above example, if you want your investment to compound, you have to re-invest the proceeds. Think about that. If you have to pay money on your loan, then you will have less to invest, or re-invest. That money won't compound. That's why you break even when you have a loan and an investment at the same rate at the same time.

I can't make it any simpler than that. An investment is just the other side of a loan.

 

[ThoracicGuy]

I appreciate your input. I see a few points that could make your statement not applicable.

1- For Student loans, I have never seen or heard of a 30 YEARS payoff term. Usually it's 10 years, or if you refinance its 12, 10, 8 , 5 or less. I have never seen 30 YEARS. Correct me if I'm wrong on this.
2. The choice is not whether we should pay off student loans or not. The point is to pay off AS FAST AS POSSIBLE to minimize the damage of interest. Basically fighting against TIME. SO if you can pay off the loan ASAP, the gain is NOT just ONE TIME GAIN. It's a GAIN FROM preventable YEARS (12, 10, 8, ect. years) of COMPOUND INTEREST. Would you agree on this?
3- I totally agree with you that Today dollars are worth more than in ten years and more time compounding better. HOWEVER, like my original point, there is NO GUARANTEE GAIN in investing.

Please share your thoughts on my points above. Thanks

I have student loans that have a 30 year term at 3.375%. I'm still paying them off sooner.

 

[dynx]

Out of curiosity...

For those of you who favor paying off loans before investing, do you also favor extra loan payments over contributing to 401k, IRA, and/or HSA?

Just my thoughts on the issue. i have to mostly agree with Bc65 in this thread. Im not risk or debt averse and for the last several years was mostly in equities and making my standard mortgage payment. As the market has been favorable and P/E ratio's rise I see most companies with lower expected returns than I'd like Ive transitioned to overpaying my 4% mortgage and will continue to do so till there's a market correction. Its not an either or thing I still put a couple k in the market every month in case I'm wrong but in aggregate at >4% I'd pay the loan, at 3% I'd keep it.

To answer the above question specifically of course you should still max out your tax advantaged accounts especially at a top tax rate.
In regards to mortgage interest deduction, at a high salary with a reasonable mortgage its nothing.

You can just go with expected market returns sure, afterall as they say past performance is a guarantee of future results. Slam 7% into a calculator and investing in the market will win because you input the victory into your calculations. If you model expected returns for individual companies it becomes a little more difficult to find good deals these days, if you buy only index funds well then good luck with figuring your expected return in any real mathematical fashion.

Those are my generic thoughts and where I'm at after running the math. Individual situations may vary. Thats why people are buying bonds. The risk free rate of return is <2%. To dismiss this as *****ic based on a presumption of a 7% return in stocks is done at your own risk. This isnt stupid money, there's a price and time for protection of principle and its at a premium right now. Thats not because very smart people dont bother to do math.

 

[Plastikos]

I have student loans that have a 30 year term at 3.375%. I'm still paying them off sooner.

I would as well, 30 years is a long time and will amount to a lot of unnecessarily avoidable interest. Especially since even a small over payment early on then has a good sized effect. I still pay a small nominal amount over all my loans just cuz I can, but I do mean small, for the mortgage its like 3% of the monthly and the nominal amount is so small that it is unnoticed and doesnt affect anything else.

How did you get bonds paying that much, 3.5-4.5%? You must have them a long time. I don't trust California municipal bonds. Some have defaulted. If I were to buy bonds, I would do if for the guarantee, i.e. treasuries.

They are muni bond CEFs, closed end funds. You can get that yield today, it was much better. All bonds carry risk of default, however muni bonds are the closest you can come to treasuries safety level wise. While defaults are prominent, they are very rare, and the return on a default for muni bonds is much higher than that in corporates or elsewhere. For us in the high tax brackets, theyre great. Many of the funds have a ton of GO bonds, which are very safe, unless you think we wont have to pay taxes anytime soon. Most of these funds carry leverage and in your case you have to make sure to avoid it.

 

[Plastikos]

Just my thoughts on the issue. i have to mostly agree with Bc65 in this thread. Im not risk or debt averse and for the last several years was mostly in equities and making my standard mortgage payment. As the market has been favorable and P/E ratio's rise I see most companies with lower expected returns than I'd like Ive transitioned to overpaying my 4% mortgage and will continue to do so till there's a market correction. Its not an either or thing I still put a couple k in the market every month in case I'm wrong but in aggregate at >4% I'd pay the loan, at 3% I'd keep it.

To answer the above question specifically of course you should still max out your tax advantaged accounts especially at a top tax rate.
In regards to mortgage interest deduction, at a high salary with a reasonable mortgage its nothing.

You can just go with expected market returns sure, afterall as they say past performance is a guarantee of future results. Slam 7% into a calculator and investing in the market will win because you input the victory into your calculations. If you model expected returns for individual companies it becomes a little more difficult to find good deals these days, if you buy only index funds well then good luck with figuring your expected return in any real mathematical fashion.

Those are my generic thoughts and where I'm at after running the math. Individual situations may vary. Thats why people are buying bonds. The risk free rate of return is <2%. To dismiss this as *****ic based on a presumption of a 7% return in stocks is done at your own risk. This isnt stupid money, there's a price and time for protection of principle and its at a premium right now. Thats not because very smart people dont bother to do math.

Worrying about where we are in the market cycle isnt a fruitful endeavor, so I dont worry too much about those things. When bc65 chose 7% it was just a random number, and didnt matter since it was equal, which was his point. Its not about who's right or wrong as long as people actually understand the math and how it works, which it seems they often dont, even after long drawn out discussions. Everyone can do what they want for their own personal reasons, and we really shouldnt care too much. These are basically all good decisions when it comes down to it.

As stated in my examples, real life return and interest rates make investing a much better probability than paying down a loan that is near inflation than the very generous example above. And as shown, I used a rate that was nearly half of the loan and still came out ahead. Everything is dependent on time frame and your goals, if you're thinking about what the market does in the next quarter to year and looking for validation on your choice, that is not the right mindset. The whole point of the exercise is to show that very long term (20+ years) its hard to lose in the market with any reasonable portfolio and consistency.

 

[dpmd]

This is a topic that can get very complicated very fast which is why you see people with all kinds of different opinions. It usually isn't the easy lump sum payment versus lump sum investment calculation. More often it will involve things like paying other types of debt or different investment options. The advice for someone asking if they should make extra loan payments or contribute to a 401k with match is going to significantly differ from the advice for someone who has maxes out all retirement options and is debating between a taxable investment account or paying off a loan. We also can't ignore things like the time frame they have left for investing or their expected income changes (the same advice may not work well for someone whose income is going to drastically increase soon versus someone with uncertain income outlook). There isn't a one size fits all answer.

 

[dynx]

Worrying about where we are in the market cycle isnt a fruitful endeavor, so I dont worry too much about those things. When bc65 chose 7% it was just a random number, and didnt matter since it was equal, which was his point. Its not about who's right or wrong as long as people actually understand the math and how it works, which it seems they often dont, even after long drawn out discussions. Everyone can do what they want for their own personal reasons, and we really shouldnt care too much. These are basically all good decisions when it comes down to it.

As stated in my examples, real life return and interest rates make investing a much better probability than paying down a loan that is near inflation than the very generous example above. And as shown, I used a rate that was nearly half of the loan and still came out ahead. Everything is dependent on time frame and your goals, if you're thinking about what the market does in the next quarter to year and looking for validation on your choice, that is not the right mindset. The whole point of the exercise is to show that very long term (20+ years) its hard to lose in the market with any reasonable portfolio and consistency.

Wasnt replying to anyone in particular. Just saying that each individual should do the math for themselves and there is a component of "cost of safety" involved especially as you get older that shouldnt be ignored.
Worrying about market cycles isn't my thing. Im not smart enough to time the market but certainly you need to look at the cost of what you're paying for especially if you dont have the means to ride out a drop. Are you going to do just fine paying for colgate with a PE of 40 and holding for 40 years. Probably. But is your money better put to work somewhere else, also probably.

 

[ISuckAtLife]

In regards to mortgage interest deduction, at a high salary with a reasonable mortgage its nothing.

Let's say a high salary is private practice specialist income (550K). Generally, a reasonable mortgage is equal or less than 2x your gross income. In this case, that's about $1 million.

Using your 4% mortgage rate, that's $40,000 of interest a year. Given the highest tax bracket, that's a deduction of about $16,000 every year for the entire term of the mortgage. The effective interest rate becomes (40k-16k)/1000k, or 2.4%.

Regardless of how much your loan actually is, the reduction in the effective interest rate is the same in the highest tax bracket. How is this "nothing?"

Also, just to address a previous post, you can still take a mortgage deduction with AMT.