Pay off debt or invest?

[maat55]

I agree with you here. Most people allow their income to dictate their lifestyle. More money = more stuff. What should really happen is that as income rises, debt should get paid off and savings should get built up. Sure, you want to enjoy some of the fruits of your labor, but you don't need to spend all the extra you are earning. You'll be a lot better off in the long run if you keep living lean and get rid of debt and build savings rather than elevating your spending to match your rising income.

That said, this is not the topic of this thread. Debating what OP should or shouldn't have done in the past isn't really of value to the OP (though it might be helpful to others reading this who are at a different stage of life). OP is already paying an extra $20,000/year to debt repayment, which is great. The question is if he should continue to do so or slow down the debt repayment and put more in investments.

I have to disagree, I'm reminded when Dave say's personal finance is 80% habit and 20% knowledge. What I see is an OP with a 125k noose around his neck and no great concern about it. People who learn to be comfortable with debt never really get out of debt and make bad consumer debt choices along the way.

Great incomes are not a garantee, using it to unload the debt would be my first priority. My reflecting on his past is also a warning for his future. There's plenty of advice to go around, I'm just giving him food for thought.

[LivingAlmostLarge]

Maat, you're approaching the debt from only one perspective, debt. Not looking at the larger picture.

They have high incomes, but they need to secure some sort of EF more than $7k because they have these bills which are $600k. Even with their incomes it will take time to clear their debts.

Unfortunately until they clear $600k the bank can come in and foreclose on the house. Hence if they lose their job(s), they need money not in retirement accounts to tide them over until they can find jobs.

Reality, you can't live for years on end without an emergency happening. And the higher the income the longer it usually takes to find a job. They will likely get severance depending on what fields they are in, but no one should count on it.

Plus they have to still make their monthly obligations, and by your method if they lost their jobs, what would they stop paying? There isn't much you can stop paying.

Truth is what's done is done (like debt and children). They can't go back and undo student loans, and they can't undo kids. And it seems like the student loans were a pretty good investment if they are raking in $200k+/year at 31 with potential to go a lot higher. ROI on student loans is looking mighty good.

Wisely because they are stashing $31k/year into a 401k, they are able to save for retirement. That would only be about 60% towards debt anyway with their incomes. So it would only pay off $18k/year extra. Almost 50% loss off the top, not worth it at all considering their interest rates.

Now, if they focus on not increasing their lifestyle in the next 3 years they should be golden.

[disneysteve]

My reflecting on his past is also a warning for his future.

Good point. One thing you don't want to do is make the same mistakes over and over again, which is what too many folks do. While you can't change the past, you can change how you handle things going forward. I've said before, and it goes along with what you are saying, that mindset is really important.

[Scanner]

I have to disagree, I'm reminded when Dave say's personal finance is 80% habit and 20% knowledge. What I see is an OP with a 125k noose around his neck and no great concern about it. People who learn to be comfortable with debt never really get out of debt and make bad consumer debt choices along the way.

Au contraire, Matt.

I don't get any sense that the OP is somehow lackadasical about reducing debt.

I realize you are a Dave Ramsey cultist but debt does serve a purpose.

(it's okay, there are Vanguard Cultists here too and I am a "Silver Bug")

The OP makes 210K/year and obviously, by the breakdown below, he and his wife have invested a lot into higher education, and probably into careers that nobody wants to do (thus the high pay. . .if they were social workers, they wouldn't be making 210K/year).

I see his financial future as pretty strong, even if he just continues with an extra 20K/year of debt reduction.

What many here don't realize is when you make 210/year, you are going to be taxed to hell. . .so putting down an extra 20K/year is really nothing to sneeze at as he probably only brings home 100K/year after taxes.

Many here just see 210/year and automatically assume that's what he takes home.

(just like many of my patients pay me $40 and think I shove that into my pocket)

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%

Personally, I'd retire the student loans first, unless the term is under 10 years. Then I'd do the HELOC. If the term of the student loans is close. . .then just let that die a natural death and do the HELOC and add 20K/year to reducing that.

[noppenbd]

What many here don't realize is when you make 210/year, you are going to be taxed to hell. . .so putting down an extra 20K/year is really nothing to sneeze at as he probably only brings home 100K/year after taxes.

I think that estimate is off. That would amount to more than 50% paid in taxes. Federal income tax on 200K of taxable income is "only" $45K, and that is assuming he doesn't have substantial deductions. Add in state, FICA, and property, and I doubt you are close to $110K in taxes a year. Probably closer to $60-70K a year.

[Scanner]

Yeah, I estimated a possible 55% taxation rate, but I was only figuring in probably very high property taxes. Point is. . .with student loans. . .I suspect this person is leading more of a middle class lifestyle than you may suspect.

I also allowed some discrepancy if he is self-employed. . .who pay more tax in this country.

[LivingAlmostLarge]

Actually if they make $210 - $31k = $179k taxable income, assume no other deductions. Plus AMT might kick in. -$10.5k personal exemption - $10.9k standard dedution = $157.9, using fairmark,
Reference Room, they'll owe $32.9k. Then add in 6.2% SS up to $102k = $6.3k x 2 = 12.6k, 1.5% medicare = $3.2k = $48k minimum before state income taxes, $162k before state taxes, medical, $31k/year child care, etc. They are working off of $131k - $20k debt repayment extra, not counting the minimums on everything.

If they stopped the 401k, basically they'd be screwed tax wise, paying a lot more.

[noppenbd]

Yeah, I estimated a possible 55% taxation rate, but I was only figuring in probably very high property taxes. Point is. . .with student loans. . .I suspect this person is leading more of a middle class lifestyle than you may suspect.

I also allowed some discrepancy if he is self-employed. . .who pay more tax in this country.

Since he has 401k with employer match & bonuses, I doubt he is SE. Also don't forget 30-40K a year in bonuses above 210K income. So I have no doubt that lifestyle is comfortably upper-middle class. Nevertheless, his attitude seems right, and 401k balances are 170K, which suggests this is not a new phenomenon. There is always room to cut more, but OP seems to be doing ok in my book. I would definitely build up EF to 3 months of expenses rather than pay down debt.

AMT is a good question, can OP address it? If AMT is being paid it may change the equation slightly.

I definitely agree he should keep 401ks fully funded since cash flow does not appear to be a major issue.

[Scanner]

I accept your number crunching.

My point is that I think Maat is thinking there is a lot of discretionary income there up for grabs for debt reduction and while perhaps they could increase it some. . .my gut tells me there isn't much there to work with. With 100K in student loans, that's probably $800-1300/month right there, depending on the term.

You guys present a good proof on why you have to consider taxes into the equation.

I float a small amount of debt at my business and I face that dilemma all of the time. . .sure, it would be nice to get rid of the $200/month loan payment on my business LOC but then again. . .I'd have to pay that "after taxes" so I usually just keep "revolving it."

As you note, for tax reasons, I wouldn't make the 401(k) the sacraficial lamb.

[LivingAlmostLarge]

Hell no, I only considered them employees, with self-employment double my SS and Medicare numbers which is a heck of a lot more.

Plus cutting the 401k is a terrible idea, especially since I forgot about the $30-40k bonuses.

I too believe they aren't living high off the hog. The huge number is the $31k/year child care from already taxed income! OUCH! That is painful and cuts deep into their pocketbook.

After assuming no AMT, which would make their tax bill bigger, they are looking at living on $101k/year for mortgage, minimum debts repayments and basic living expenses. This is pre-state tax, which is 9% in CA at their income so they'd be down another $20k potentially in state income taxes.

People in that bracket need to be extremely conscious about taxes. Belt-tightening in other areas is better than just saying "cut 401k." Focus on debt.

Consider repercussions for taxes.

[jIM_Ohio]

Jinco- what I see is a need for tax planning before you make the decision to pay down the debt.

You are in a situation where if someone can save you 5% of the 210k you earn each year, we are talking about $11k. 10% would be 21k.

That is the difference between 33 and 28% tax bracket, or the difference between 35 and 25% tax brackets.

Consider tax planning to
a) avoid the amt
b) set aside money before taxes (into 401k, HSA and other accounts)
c) manage the debt as part of a larger scale financial plan

[JinCO]

We did not have to pay AMT last year but I think we may be getting close to the threshold. I am forecasting / budgeting our take home to be around $150K after taxes for this year. I don't know what other levers we have to lower taxes besided maxing out 401Ks. We have discussed meeting with a tax advisor...seems like it would be a good idea. I am especially worried about what could happen in a few years based on what I've read about Mr. Obama's tax policies.

[JinCO]

It seems like a lot of the posts are saying that we have been financially irresponsible by accumulating so much debt. When making the decisions to go to graduate schools and finance via student loans we fully undertood the financial implications of both paying off the debt and increasing our lifetime earning potential. I get the sense that most people in this forum are very debt adverse and wouldn't take out huge student loans to finance education. When deciding to take on this debt we viewed this as an investment in ourselves. We were making decent money before graduate schools but now have a much higher top end earning potential.

[jIM_Ohio]

It seems like a lot of the posts are saying that we have been financially irresponsible by accumulating so much debt. When making the decisions to go to graduate schools and finance via student loans we fully undertood the financial implications of both paying off the debt and increasing our lifetime earning potential. I get the sense that most people in this forum are very debt adverse and wouldn't take out huge student loans to finance education. When deciding to take on this debt we viewed this as an investment in ourselves. We were making decent money before graduate schools but now have a much higher top end earning potential.

Jinco- you hit the nail on the head so hard you only needed to swing the hammer once.

Most people on this board are debt averse. In addition there are people here which can squeeze every last penny out of a budget if you need that assistance.

Hopefully you saw that I did not criticise the debt load. More than likely what you need is a plan, and what I see is the desire for a plan, and a lack of knowledge of what the various issues you need/want/would consider.

For example- what are your goals? You did not state anything to really form a plan on. And to this forum's credit, many people assumed you need/want a debt free goal (and want that goal achieved soon).

In defense of the board, your first paragraph read

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.

I saw the last paragraph and considered this the goal

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?

Most people's advice was not to shift from debt reduction to accumulation.

I will again state that my advice would be to accumulate as much as possible (as much as you are comfortable with relative to the debt load). 15k into the 401ks is not enough (IMO). 15k is 7% of 210k. You need to double that savings rate.

You need to do a timeline of the following:
1) when will each debt currently be paid off (with no extra payments)
2) when will each debt be paid off (with current 20k of extra payments).
3) if you invested the 20k (or a portion of it), how much risk would you take with it, and what return would you expect?
4) as debts got paid off, what would you do with the money allocated to the debt?

1) and 3) are really the same plan- this considers more money is invested now, net worth will be proportional to investment performance from the start (more or less) because the debt will be around for a long period of time and decrease slowly. When debt is paid off net worth and retirement accounts will be quite high.
2) and 4) complement each other. This considers the money from debt 1 being paid off is either then invested or applied to debt 2. When debt 2 is paid off, you will apply the money to investments or debt 3. Net worth will go up real slow (relative to case above), but debt load decreases real fast. Generally speaking, you can only catch up to first scenario if you increase savings rate.

plot a timeline with the following numbers crunched:
a) debt load each year
b) net worth each year (this would reflect less debt year over year, and increased home equity year over year, in addition to retirement accounts)
c) retirement account value each year (only include money invested for retirement or long term spending).

You need to run 1) and 3) with outputs of a-b-c
You need to run 2) and 4) with outputs of a-b-c

You need to run 1) and 3) and see a savings rate of 16% compound over time. When you run 2) and 4), you need to realize your savings rate is about 7%, and to retire you will probably increase savings rate to about 25% to reach same goal/net worth/ retirement account size as the 1) 3) scenario.

Note the reason for a timeline is so you can see what it costs you. If student loans have a 5 year repayment period, it might make more sense to pay them off sooner, then invest that whole student loan payment and the extra 20k (debt paydown) once the student loans are paid off. If the student loans have a 30 year repayment period, not paying them off sooner will probably work out better.

Each situation is different. The primary issue is the 20k you apply to debt and the proportion the 20k is to the size of the debt and the monthly payment you save when debt is paid off.

Either scenario is OK (2-4 has less risk than 1-3); 1-3 has higher probable return than 2-4, higher net worth and more risk.

If you are comfortable managing the risk, then you can make a good decision (which is what I assume you posted here to determine).

This is just the start.

Then you need to look at current tax return and see if you can do the same plan above (1-3 or 2-4; whichever you choose), but get more money working for you (based on tax savings, such as an HSA, or using tax efficient investments). Creating a small business would also help.

You would also need to factor in mid term problems. New car needed? Emergency fund? Health care spending now and in future. Child's education? Continuing education for you and spouse.

These would impact taxes, so if you have a goal, state it.

My advice will center around a broad financial plan which
a) sends at least 15% of gross income to retirement
b) keep spending moderate (spend less than you earn)- spending is calculated on net pay with 15% of gross already deducted. 15% of 210k is 31.5k per year (this is the amount I would suggest you invest for retirement each year).
c) keep debt to a minimum
d) build a broad financial plan to diversify risk, stay involved in community (give back) and do what makes you feel good.

[noppenbd]

I will again state that my advice would be to accumulate as much as possible (as much as you are comfortable with relative to the debt load). 15k into the 401ks is not enough (IMO). 15k is 7% of 210k. You need to double that savings rate.
.

Jim, OP first post says that both him and wife max 401ks; I take that to read that they put in 15.5K each, meaning 31K per year. So they are already saving 15%.