Pay off debt or invest?

[JinCO]

My wife and I have a considerable debt load in the form of our home mortgages and student loans. Our focus in the past couple of years has been to reduce the interest rates where possible through consolidation or new loans and attempt to pay off as much debt as we can as quickly as we can afford to.

Our current debt load is:
Primary Mortgage: $405K @6.25%
Home Equity LOC: $70K @ 4.49% (tied to prime so will rise as prime increases)
My student Loan: $35K @ 4.12%
Wife's student Loan: $90K @ 3%

We are currently paying down each of these line items faster than we are required to. The issue with this approach is that we do not have anything left over to invest except for our 401K accounts. We both max our 401Ks at $15.5K per year. I receive a 7% employer match and my wife receives a 4% match.

I am trying to figure out at what point it makes sense to switch some of the money we are paying on our debt to investments. We are currently paying about $20K more than we need to on our debt items. Should we reduce some of the amounts we are paying on our debt items and purchase stocks or other investments?

[noppenbd]

Other info is needed:

-Current yearly income and expenses (before and extra debt payments)
-Current investment balances
-Ages

[jIM_Ohio]

Originally Posted by JinCO

My wife and I have a considerable debt load in the form of our home mortgages and student loans. Our focus in the past couple of years has been to reduce the interest rates where possible through consolidation or new loans and attempt to pay off as much debt as we can as quickly as we can afford to.

Our current debt load is:
Primary Mortgage: $405K @6.25%
Home Equity LOC: $70K @ 4.49% (tied to prime so will rise as prime increases)
My student Loan: $35K @ 4.12%
Wife's student Loan: $90K @ 3%

We are currently paying down each of these line items faster than we are required to. The issue with this approach is that we do not have anything left over to invest except for our 401K accounts. We both max our 401Ks at $15.5K per year. I receive a 7% employer match and my wife receives a 4% match.

I am trying to figure out at what point it makes sense to switch some of the money we are paying on our debt to investments. We are currently paying about $20K more than we need to on our debt items. Should we reduce some of the amounts we are paying on our debt items and purchase stocks or other investments?

I would look at the following- with current 20k extra payments, when will each debt be paid off?

If all 20k extra was applied to one loan (student loans is where I would look first), how soon would it pay thay loan off?

More than likely you will see some trends:

sending all 20k to one loan is better than sending 5k to 4 different loans.

investing a portion of the 20k will probably come out ahead (net worth wise) than paying down the debt.

you need to track this based on the date you would have zero debt, the tax writeoffs the various loans offer you, and how much risk you want to take.

[disneysteve]

Without anymore info, I'd have to say that making extra payments on loans with interest rates under 4.5% isn't the best option. Investing in a diversified portfolio would more than likely outperform that and earn you more money in the long run (though there is no guarantee of that).

At the very least, I'd let the 3% loan die a natural death. The 4.12% and 4.49% loans are a little more toward the borderline. If you count your loan prepayments as the fixed-income part of your portfolio and invest aggressively with your 401ks, that could make perfect sense. Depends on your ages, risk tolerance, etc.

[JinCO]

Other info is needed:

-Current yearly income and expenses (before and extra debt payments)
-Current investment balances
-Ages

1. Our annual income is $210K + $30 - $40K in non guaranteed bonuses. Our budget is currently set so that it nets at $0 each month so our expenses are equal to our income (after taxes, 401Ks, etc.) for 7 months out of the year. We are both paid bi-weekly so in March and December we earn about $5K more than we spend. In Aug, Sept, and Feb we receive bonus pay outs which usually net to $25K - $30K after taxes.
2. Approximately $170K in 401Ks
3. We are both 31

[noppenbd]

With your income you are probably in 28 or 33% bracket after bonuses depending on deductions. If you are comfortable investing and taking some risk, I would not pay extra on any of your debts at current interest rates. You can probably outperform the costs of your debts by investing. First, I believe you can make nondeductible IRA contributions and roll over to Roth IRA in 2010 when MAGI limits expire. Second you could invest in tax-managed funds or ETFs in an after-tax brokerage account. If HELOC rates go up or your situation degrades you could move lump sum funds from after-tax account to pay down debt. In addition, make sure you have at least 3 months of expenses in liquid savings.

[JinCO]

Thanks for the response noppenbd. I didn't realize that ROTH IRA MAGI limits were set to expire in 2010. I'll do some research on the investment products that you mentioned. I have to admit that I'm a little ignorant on my investment options, but I'm trying to learn. Thanks for your advise.

[maat55]

I think you have too high of expenses. You bought too much house before you paid down your debts. You have a high income, there is no reason you should not be able to pay your debts faster other than you just want too much stuff over being debt free first.

You need to step back and ask yourself what is more important at this time, my stuff or paying off debt.

[JinCO]

maat55 -- thanks for your response, but I'm not sure your advise is accurate. Our home is fairly entry level for the area that we live in. When we were shopping mortgages our lender suggested that we could be approved for a loan of $800K - $900K, but we chose a much less expensive home so that we could pay down our debt. Our largest monthly expense is childcare for our 1-year old. We both work full time and 50 hours of care per week is a significant expense. In terms of other expenses, I think we are more on the frugal side. We don't eat out much, don't travel much, don't drive expensive cars, etc.

I'm not sure I understand your point. Are you saying we should not have purchased a home until our student loan debt was paid off? I don't know that it would have made finanical sense to rent given the tax implications.

[LivingAlmostLarge]

It really depends on how much you make. It's very sensible to maximize the 401k because of the income. It saves you a bundle in interest.

I too might let the 3% interest ride and the primary mortgage. I'd probably pay off your student loan or the HELOC because the interest rate could rise.

Do you have an adequate emergency fund or taxable accounts to tide you over if you happen to lose your jobs?

Right now you have some very cheap loans. If you are pretty aggressive investor, which I am, I would start investing in taxable accounts.

Also do not think to rollover a non-deductible IRA in 2010 because of your income, it might not be worth it. You'll save maybe $30k between you and your wife. And you'll pay maybe 35-40% in taxes. I wouldn't do it. It will push your income in 2010 to a much higher level, unless you are not working or something.

People think the roth is the best retirement vehicle. It's good, but not perfect. It depends on the bracket you're in mainly and what state you live, if you pay high state income taxes it might not be worth it.

[disneysteve]

Originally Posted by maat55

You bought too much house

Originally Posted by JinCO

we chose a much less expensive home so that we could pay down our debt.

JinCO - How much was your home? On an income of $240,000, 3 times that would be $720,000 which is one rule of thumb for affordability. Another rule of thumb is that no more than 28% of income should go to PITI. Do you fall within those guidelines? If so, I agree that the house is okay on your income (not that that was your question).

It sounds like you are doing just fine and living well below your means since you are both maxing out your 401k plans and paying an extra $20,000/year on your debt. That's $51,000/year going to savings on an income of $240,000. That's a savings rate of over 21% which I think is just fine.

[JinCO]

LivingAlmostLarge - thanks for the advise. We don't have a very large emergency fund -- about $7K in primary savings account. It is hard for me to justify having a large emergency fund when I'm paying interest on money that I owe and earning very little in the savings account. I know that it probably makes sense to build up more money in this area. We do have about $30K in the HELOC that we could tap into @4.49% as a last resort. What do you mean by taxable accounts?

[disneysteve]

Originally Posted by JinCO

What do you mean by taxable accounts?

Mutual funds, stocks, ETFs, etc. that are in a taxable account, not a retirement account.

[JinCO]

disneysteve - We paid $540K for our home which seems reasonable given the metrics you provided. Thanks for the answer re: taxable accounts...I'm somewhat of a rookie in terms of financial lingo.

[LivingAlmostLarge]

I think $540k is a very good amount when you make about 1/2 that much. It's definitely within the guidelines and probably why you are able to pay off so much debt. I disagree with maat, you didn't buy too much house. It's likely under the 28% even with 2 mortgages. It just looks like a lot of debt, but at your age and income it'll clear faster than you expect. Plus I am not sure wher e you live but $540k barely buys starter homes in some areas.

Okay $7k is not good. And you have low interest loans. I would not count on a HELOC as an emergency fund. You'd hate to be digging in a hole when you have no job.

What'd I'd do? Personally I'd start stashing a bunch of cash, until you have at least 6 months of expenses in cash. Maybe it's the $20k extra.

Next step, is I'd keep all my loans, but I'm an aggressive investor. I'd just pay minimums and invest the difference. Now if prime looks like it's going up then I'd pay it off.

For a less aggressive position, I'd try to clear the HELOC because the rate is variable. Another reason to clear it over the student loans is if you die student loans go away but not HELOC.

Not to be morbid, but it's just a thought. So keeping the $90k around is not a huge deal. It's cheap, although not tax deductable.

I think all your loans are manageable on your income. Also I think that with your income, clearing the loans are not necesarily in your best interest. There are other area that need to be maintained.

Also before you start repaying loans, consider having a car fund set up and diverting some cash for car maintenance or car replacement.

[cptacek]

Our current debt load is:
Primary Mortgage: $405K @6.25%
Home Equity LOC: $70K @ 4.49% (tied to prime so will rise as prime increases)
My student Loan: $35K @ 4.12%
Wife's student Loan: $90K @ 3%

I would start investing, firstly in a Roth IRA for both of you. The two student loans are very low interest already. The two mortgages are tax deductible, so if you are in the 28% tax bracket, the effective interest rates are 4.5% and 3.23%.

The student loans aren't tax deductible, are they, because of your income? If they are deductible, they are even lower interest.

[disneysteve]

Originally Posted by cptacek

I would start investing, firstly in a Roth IRA for both of you.

Probably not eligible due to income. MAGI needs to be under $166,000.

[maat55]

Originally Posted by JinCO

maat55 -- thanks for your response, but I'm not sure your advise is accurate. Our home is fairly entry level for the area that we live in. When we were shopping mortgages our lender suggested that we could be approved for a loan of $800K - $900K, but we chose a much less expensive home so that we could pay down our debt. Our largest monthly expense is childcare for our 1-year old. We both work full time and 50 hours of care per week is a significant expense. In terms of other expenses, I think we are more on the frugal side. We don't eat out much, don't travel much, don't drive expensive cars, etc.

I'm not sure I understand your point. Are you saying we should not have purchased a home until our student loan debt was paid off? I don't know that it would have made finanical sense to rent given the tax implications.

Yes, if making 200k + you would have lived on 70 to 80k you could have knocked out your debt quickly. Having only 20k extra to pay down debt and no sizable EF, means theres a leak in your boat somewhere. Your home is not a problem when you are debt free, but for now you could have concentrated more on the debts first.IMO.

[Scanner]

Here's one piece of advice to add to the hodgepodge here. . .I would consider your "debt reduction" the "bond part" of your portfolio.

Redeploy your 401(k) to the most aggressive funds you have available to you for choice to give you a "balanced approach" to wealth accumulation/increasing net worth.

So. . .you are putting 31K/year into both 401(k)'s. . .and 20K into debt reduction.

For instance, I would maybe put 50% on a sector fund like healthcare or technology and 50% in international. . .then the other 20% goes to your "conservative investment" - debt reduction.

[LivingAlmostLarge]

Actually maat, a better way to have paid off their debt because their mortgage is probably around the same as renting is NOT to have had a kid.

I bet that the daycare is almost the same as the mortgage! So delay kid one year = debt paid off faster.

But who wants to wait for kids? Not the house, I bet without $2k/month daycare, how much do you pay JinCo, is it close to your house payment?