Advice on debt RE: student loans/house mortgage

[somaziro]

The first thing that I hear when learning about investing is to get your debt under control. I have just graduated from law school and will have debt of 55,500 in federal loans at varying degrees of interest (see below). I also am planning on saving all my money for 1 year after graduation to have 10% to put down on a house, the top of my range is a 135,000 house.

Given that I have crunched some numbers below.

The decision I have to make is whether I should pay 700 a month to paying down principal on my debts or if I should invest 700 a month. I guess the question is over the long run, will I get better returns on that 700 a month invested vs. the interest that I won't have to pay if I paid off my debts.

DEBT
House
135,000 dollar house
with 10% down would be 122,500 loan

taking out a 30 year loan at 6% interest payments would be $735 a month payment

only paying the minimum on the mortgage it would take me 30 years to pay off loan and would pay 141k in interest

paying an extra 300 a month to principal it would only take me 15 years to pay off mortgage and only pay 63k in interest


Student Loan
loan 1
18,500 consolidated at 2.7% over 30 years would be 75 a month

only paying minimum payments it would take me 30 years to pay off loan and would pay 8,500 in interest

paying an extra 100 dollars a month to principal it would only take me 10 years to pay off loan and only pay 2600 dollars in interest

loan 2 and 3
2 X 18,500 = 37,000
consolidated for 30 year loan at 6.7% would be $239 a month

only paying minimum payments it would take me 30 years to pay off loan and would pay 49k in interest

paying an extra 300 a month to principal, it would only take me 7 years to pay off loan and only pay 9,700 in interest.


Total Interest over time
only paying minimum payments means that that end up paying 200k in interest for a house and student loans and I would be in debt for 30 years.

paying an extra 700 to all principals as shown above would drop that down to about 75k in interest and be completely out of debt in 15 years.


I guess the question comes down to whether I would make more investing 700 a month over 30 years than the difference between 200k interest and 75k interest... 125k. If I would make more over 30 years, then I should invest, if I would make less, then I should pay off the principal and be debt free in 15 years?

In any event, I was already planning on paying 10% of what I bring home every month into investments for retirement/future so if I chose to invest that 700 it would be on top of the 10% already invested.

My gut tells me to use that 700 to pay off debt and be free of it in 15 years. I have never been really good at math, but the difference between paying 200k in interest and 75k in interest seems like alot of money to me. I feel like I am probably missing something though.

Any suggestions, comments? Thanks!

[Adrienne]

Interesting. I just started writing a trilogy on these types of topics on my blog. The article I am currently writing is about this exactly.

I am a big proponent of being debt free. There are lots of pluses to having very low overhead such as being able to save, and IF you lose your investment money you still have low over head and a place to live.

However, look at the math. You are talking about under 3 percent interest for your student loans. Heck, putting that money in a CD would get you 5 percent, you would still make money on it. I personally don’t put much in CDs except for some short term savings to get a higher rate. Average return a year in the stock market over time is 10 percent. So, you lose 7 percent interest if you pay that off.

As to the home loan, I would not pay that off either. Why? First off all, tax ride off. Second, at 6 percent, you are still making more money in the stock market then you are saving by putting it into the house.

Now, math aside, debt of any kind does not make me happy. I don’t like, I don’t want it. However, in your case, I think a happy medium would work well. I would let the student loans ride paying only the minimum (because the payment is so low and the interest is so low, you will make a lot more money investing) and focus on paying off the house by paying say 1.25 percent of your mortgage payment. This will still start getting it paid off faster, you will still get huge ride offs, and you can still invest.

Now, here is the cravat. DON’T SPEND IT. If the choice is pay off the loans faster or buy a boat then you want to pay off the loans. But if you can be strict with yourself and really use that money to invest and build a good portfolio, then I think that you want to focus there.

Just my 2 cents.

Adrienne

[somaziro]

Just did some more number crunching using an online calculator

If I choose to only make the minimum payments over 30 years, and invest the 700 a month I would be paying off in principal I will end up with an extra 200k I would have paid out in interest.

Using an online calculator, if I invest 700 a month over 30 years with a 10% return, after 30 years that would be 1.5 million at the end of the period, for a profit of 1.3 million. But I would be in debt for 30 years instead of being totally out of debt in 15.

Mathematically it seems to make sense to invest the 700 and take the hit on the extra interest since I would be making more money in the end. It just feels strange to keep myself in debt instead of doing my best to get out of it (and i have 2 different rates for my student loans 2.7% for 18,500 and 6.7 for 37,000) since the mantra I always seem to read is to get out of your debts before you start investing - although I think that for the most part people are talking about credit card debt of which I have none.

Anyway, thanks for your input I really appreciate it. I will be sure to read your blog.

[Adrienne]

You’re most welcome. You will actually end up with more then that because you can ride off your mortgage interest which can save you a few more thousand in taxes which can be invested and that compounds every year as well.

It’s a tricky slippery slope and it does seem counterintuitive, but the numbers aren’t lying.

The big hint again is, if you can’t honestly make the commitment to invest it, then you are better off paying off your bills.

Glad that helped.
Adrienne

[somaziro]

sorry for rambling, just did more numbers

say I pay off each loan the way I had thought about, 700 a month going to the different principals and end up paying off the 6.7% loan in 7 years, the 2.7% in 10 years, and my house in 15 years, and THEN invest what I was paying in principals. well it looks like after 30 years if I did that I would end up with only ~500k. While if I invested the 700 a month from the get go, and just took the interest hit and only paid the minimums I would end up with 1.3 million after 30 years even subtracting the extra interest I would have paid.

mathematically it definitely seems to make better sense to just pay the minimums and invest the 700 instead of paying off principal. Psychologically it just seems wrong though, there is for me (maybe others) just something that feels wrong being in debt. Maybe it is just a mind thing that I have to deal with and just think that in the end I will have made roughly 700k more after 30 years. I don't know the answer.

This is all assuming a rate of return of 10%, but that doesn't really matter since whatever the rate of return is it will theoretically be the same in either hypothetical, so % wise the difference between paying debt off early vs only making minimum payments should be the same in the end.

by the way, thanks to the community for letting me work this out in public haha =)

[ken nubo]

The best debt is no debt at all. That's why I skipped college and went into business myself. But that's just me

[Adrienne]

somaziro

I finished the post on this subject. I crunched a bunch of numbers for it and there is a lot of math in it for you, but it should explain the point i was trying to make.

Adventurous Philosopher » Blog Archive » Ask Adrienne: Debt – Money 2

Adrienne

[Pat P.]

Congrats on your graduation. I have a different take on this deal.

First, you are not taking into account taxes. If you are taxed in the 25% bracket (which is likely), a 5% CD will return effectively around 4%, which will barely keep up with inflation. So in order to beat taxes and inflation you need to invest into a vehicle that has returned over 10% over a long period of time (at least 5 years). Therefore, it would be wiser to pay off part of your debt in the first year instead of saving for a house.

Second, you are assuming you will have your income (wages) for as long as you keep your debt (15 or 30 years on the two scenarios your are contemplating). But statistics tell us that the average time in a job is about 4 years (From "48 days to the work you love", by Dan Miller), so in the period of time you are considering you would change jobs/be laid-off at least two or three times, adding much more stress to your finances.

I'll suggest a different approach. If your total debt right now are the 55K of students loans you have mentioned, pay them as soon as you can. I don't know what are the entry salaries for law graduates (I am an engineer ) but assuming a 65K a year take-home salary, if you get intense you could be clear on two years or less. This means living with 35K and paying off around $2400 a month.

Now, say that you are debt free at the start of the third year. Now you can take those same 2400 you were paying on your students loans, and in six months have an emergency fund of about 15K.

After that, you can start thinking about a house. If you are planning to buy a 135K house, you could buy it for 25% down in a year, or if you really don't like debt, do a 100% down payment in 4. Notice that if you lose your job or have any other kind of emergency, your emergency fund could help you pass them, without disrupting your long term plans. Remember that after the emergency you have to restock the fund.

This may sound an extremely crazy approach, but you could be debt free, have an emergency fund and a house in less than 7 years. Also, I have not considered you can increase your income (which is likely) substantially on this period, which can make the plan easier to bear or accelerate the goal achievement.

If you are more interested in this approach, look up for one of Dave Ramseys "Total Money Makeover", or catch a one hour of his daily radio show on iTunes.

Finally, I have done part of this stuff. My wife and I payed off 28K of debts in 10 months following Dave's plan. Now we are building our emergency fund. If you are not convinced, look for one of his shows on iTunes (its free and the podcast is only 40 minutes long).

Good luck,
Pat

PD: One more thing about taxes deductions and mortgages. Say that you have a 200K mortgage with a 5% rate. Then the interest will be 10K a year which you can write of your taxes. On the other hand, if you don't have a mortgage, you would have to pay taxes on that 10K. In a 25% bracket that is $2500. So if you keep your mortgage you are "saving" to send 2.5K to the IRS by giving 10K to the bank. IMHO that is bad math .

[Adrienne]

Originally Posted by Pat P.

Congrats on your graduation. I have a different take on this deal.

First, you are not taking into account taxes. If you are taxed in the 25% bracket (which is likely), a 5% CD will return effectively around 4%, which will barely keep up with inflation. So in order to beat taxes and inflation you need to invest into a vehicle that has returned over 10% over a long period of time (at least 5 years). Therefore, it would be wiser to pay off part of your debt in the first year instead of saving for a house.

Second, you are assuming you will have your income (wages) for as long as you keep your debt (15 or 30 years on the two scenarios your are contemplating). But statistics tell us that the average time in a job is about 4 years (From "48 days to the work you love", by Dan Miller), so in the period of time you are considering you would change jobs/be laid-off at least two or three times, adding much more stress to your finances.

I'll suggest a different approach. If your total debt right now are the 55K of students loans you have mentioned, pay them as soon as you can. I don't know what are the entry salaries for law graduates (I am an engineer ) but assuming a 65K a year take-home salary, if you get intense you could be clear on two years or less. This means living with 35K and paying off around $2400 a month.

Now, say that you are debt free at the start of the third year. Now you can take those same 2400 you were paying on your students loans, and in six months have an emergency fund of about 15K.

After that, you can start thinking about a house. If you are planning to buy a 135K house, you could buy it for 25% down in a year, or if you really don't like debt, do a 100% down payment in 4. Notice that if you lose your job or have any other kind of emergency, your emergency fund could help you pass them, without disrupting your long term plans. Remember that after the emergency you have to restock the fund.

This may sound an extremely crazy approach, but you could be debt free, have an emergency fund and a house in less than 7 years. Also, I have not considered you can increase your income (which is likely) substantially on this period, which can make the plan easier to bear or accelerate the goal achievement.

If you are more interested in this approach, look up for one of Dave Ramseys "Total Money Makeover", or catch a one hour of his daily radio show on iTunes.

Finally, I have done part of this stuff. My wife and I payed off 28K of debts in 10 months following Dave's plan. Now we are building our emergency fund. If you are not convinced, look for one of his shows on iTunes (its free and the podcast is only 40 minutes long).

Good luck,
Pat

PD: One more thing about taxes deductions and mortgages. Say that you have a 200K mortgage with a 5% rate. Then the interest will be 10K a year which you can write of your taxes. On the other hand, if you don't have a mortgage, you would have to pay taxes on that 10K. In a 25% bracket that is $2500. So if you keep your mortgage you are "saving" to send 2.5K to the IRS by giving 10K to the bank. IMHO that is bad math .

You are discounting far too many factors for example, the equity you would make in those 7 years (usually at least 3 percent a year). If you buy a house for 100K in 7 years that is almost 25 grand in equity you have made that you aren’t paying taxes on.

You are also assuming a very low interest rate. Every CD right now is about 5.25 percent. And only someone who had not done any research on investing or is terrified of any risk would plan to invest in a CD over long term.

I personally get around 18-25 percent a year on my stock, mutual funds, 401K, etc. So when I say, 10 percent when I did the initial math, that is actually very conservative. I was using 10 percent because the US stock market goes up about 10 percent a year as an average for the past 100 years.

Also if some of your investments are paper money or tax sheltered or in real-estate then you aren’t paying 25 percent tax on that yet.

For example, all my stocks I have never had to pay tax on with the exception of dividends. Why? Because as they go up in value, I don’t pay taxes on them until I cash them out.

As to student loans, why would you pay those off? If they are at 3 percent and 6 percent and if you invest that money instead and earn back over 10 percent, you still end up on the winning side of things if you don’t pay it off right away. Even 10 percent – 6 percent you are making – you end up with 4 percent more. You don’t pay taxes on that 4 percent until you cash it out so the 4 percent continues to make money on itself.

Also, if you don’t buy a house, then you are paying rent and that is money you are just throwing away anyway, might as well build equity.

Adrienne

[Pat P.]

I must said I am biased towards debt-free plans. I am not saying that they are easy to accomplish or that another plan could be slightly better from a mathematical perspective. However, I believe there is a strong behavioral component in personal finances, and that getting in debt is a riskier.

According to the provided data, the student loans carry an interest of approximately 5.4% (a weighted average of 2.7 and 6.7). Short term investment vehicles (such as CDs, money market accounts and e-saving accounts) had returned under 6% on the last 5 years. So even if you don't consider taxes, you are not keeping up with inflation, and you have not accounted for the risk of having a lost of income during the duration of the loan. You would get a better return by paying off your debts than by keeping them.

About paying rent for 7 years, Adrienne is right it; is a long period, but my estimate was really conservative. I assumed that income doesn't increase and that there is no intensity on getting to the point to be financially free, which can reduce considerably the period considered. The 100% down payment is for the ones that are really intense about not getting in debt again, and have the chance to pay nothing (living with parents) or a cheap rent. A 15 year mortgage could be the answer, reducing the amount spent in rent.

I believe that in the bottom line, we are all for wealth building. My argument is that you should try to do things on sequence and by harnessing the power of focus, first paying off debts, then building an emergency fund, then buying a house and starting investing for retirement, instead of trying to do all at the same time.

Pat

[somaziro]

thanks for the different perspective Pat.

I figured out what was wrong with my initial numbers after thinking about it for awhile. say i have 1 loan, and my 1 loan payment is 300 bucks a month. I am thinking whether I should pay an extra 300 a mo to principal or invest that extra 300 a month. when i was initially calculating the different numbers, invest v pay off, i didn't take into account the fact that once i had paid off that loan I would be investing 600 a mo (the initial payment plus extra payment).

that fact totally changed my numbers and led me to discover that over 30 years, whether i have a fixed amount i invest and just pay minimums on my loans/mortgage, or if i double my payments on mortgage/loans until they are paid off then use the total of what i was spending to invest for the rest of the years leading up to 30 years... the difference between the numbers is negligible. the only difference is being debt free from loans in 7 then 10 years instead of 30 and having house paid off in 15.

IE:

what if i pay 500 a month into investments, and pay my double payments on student loans (300 a mo/ + extra 300 a mo/ and 100 a mo/ + extra 100/mo) and 300/mo extra on house mortgage over 30 years.

for 7 years I invest 500 a month = $60,475 - for first 7 years I would only be investing my 500 a month. after 7 years I pay off 6.7 loan (was paying 300 a month plus extra 300 a month for total of 600 a month) so now have extra 600/mo to invest.

for next 3 years I invest 1100 a month (500 a mo + new 600 a mo from paid off loan debt) = $126,452 - after the 3 years are up, I have paid off my other student loan (100 a mo + extra 100 a mo payment, now frees up 200 a mo) so now have 1300 a month to invest

for next 5 years I have 1300 a month = $304,320, after 5 years I pay off house and am now debt free... the extra 300 a month goes into the investment fund and now have 1600 a month to invest...

15 years at 1600 a month, 1,934,373

after 30 years with 10% return and paying off my loans at 7 years, 10 years, and 15 years end up with 1.9 million dollars.

COMPARE

invest 500 a mo + 700 a month (all my extra payments) = 1200 a month over 30 years = $2.7 million. (I would be paying off my debt and mortgage over 30 years so there is no way to invest what I would have been paying since I am still paying it). while this is about 800k more I would end up paying 200k more interest, so difference between approaches is 600k.


SUMMARY
pay everything off end up with 1.5 million after 30 years and no debt after 15 years vs. pay minimums end up with 600k more after 30 years but be in debt for 30 years.


anyway, there are factors like TAX and emergency funds that I did not factor in. Just wanted to let you know where the numbers have taken me so far.

[Adrienne]

Originally Posted by somaziro

COMPARE

invest 500 a mo + 700 a month (all my extra payments) = 1200 a month over 30 years = $2.7 million. (I would be paying off my debt and mortgage over 30 years so there is no way to invest what I would have been paying since I am still paying it). while this is about 800k more I would end up paying 200k more interest, so difference between approaches is 600k.

I think there is a flaw in your caculation here. I reconize it because when i crunching numbers to figue this out myself i did the same thing, but i saw the error i made. Take a look at your calculation again. If you dont see your error, update the thread and i will try and explain it. It is a complicated issue, and i touched on it once.
To give you a quick hint, you are double counting your morgage interest....

Adrienne

[somaziro]

mortgage over 30 years I would pay 141k in interest
6.7 loan over 30 years I would pay 49k in interest
2.7 loan over 30 years I would pay 8k in interest...

so over 30 years I pay about 200k in interest

mortgage over 15 years I pay 63k
6.7 loan over 7 years I pay 9700
2.7 loan over 10 years I pay 2600

so with extra payments I end up paying around 73k

total savings on interest of paying early would be around 125k.

is this what you are getting at?

[Adrienne]

Originally Posted by somaziro

mortgage over 30 years I would pay 141k in interest
6.7 loan over 30 years I would pay 49k in interest
2.7 loan over 30 years I would pay 8k in interest...

so over 30 years I pay about 200k in interest

mortgage over 15 years I pay 63k
6.7 loan over 7 years I pay 9700
2.7 loan over 10 years I pay 2600

so with extra payments I end up paying around 73k

total savings on interest of paying early would be around 125k.

is this what you are getting at?

not exactly. what i am trying to say is the money you pay in interest is not as relevant as you might think.

Before i go into this, i want to restate, that i don’t like debt and i think people should strive to be debt free. When i am talking about this, i am dealing with numbers only. I honestly, (with the exception of a house) will always be out of debt. This being said, we are talking about extremes here (either pay it all off as fast as you can, or only pay the bare min). Personally, i would find a happy medium but i would focus more on investments then on debt because i will come out ahead in the end.

Now.. I wrote an article on my blog that explains this and has lots of numbers and everything and i don’t have enough time to crunch more numbers etc right now, so i am just going to quote myself. The full article can be found here.

Lets play with numbers.

Let’s pretend that I am going to buy a house. I am going to take out a loan for 200K. At the time of this writing, you can deduct interest on loans up to a million dollars loans on your taxes in the United States.

200K paid over 30 years at 6.0 % interest:

I pay 1199.10 per month

I pay 231,676.38 in interest over 30 years

Lets say now, I am making my house payment no sweat and I decide to make double house payments.

I pay 2398.20 per month

I pay 59,428.74 in interest over 9 years and 1 month.

After those 9 years I stop getting a tax ride off as well.

Now let’s say instead of putting that money into paying off the house, I instead invest it. Now personally, on average I earn about 18-20 percent a year on my investments, but I know the rule is 10 %. So for the sake of this, let’s say you get 10 % interest per year on the money you invest.

If I put 1199.10 a month into investments after 30 years, I will have 1,861,877.97 (factored in 25 percent tax per year). That’s a lot

Now, if I paid off the house instead then put double into investments. After I paid off the mortgage, it would look like this:

If I pay 2398.20 a month into investments for 21 years I will have 1,601,720.39 (factored in 25 percent tax per year).

That is a 260,157.85 dollar difference.

This is what it boils down to:

In 30 years, I end up at the same place with the house paid off and investments. I paid out the same amount. Each month 2398.20 was either invested and/or used to pay off the loan. Even tho I paid a lot more in interest to the bank, the extra investment interest more then made up for it. On top of this I have all the money I saved in taxes because I tax deduct the interest over 30 years not just 9.

Does that make sense? At the end of the example above, you have paid out the same out amount of money but have very different results. What you pay in interest is not relevant because you are paying out the same amount in either scenario. The difference is in one you pay more in interest then in the other, however, you make more because that is at a lower interest rate then what the stock market or other investments return.

Is that clear? I feel like the water is a little muddy. I am not sure i am explaining this as well as i would like.

Adrienne

[maken]

i would pay of the debt rather than save; it not nly reduces the overall interest you pay, it also improves your credit rating thus making it easier for you to get a mortgage at a lower rate.