Pay off debt or invest?

[jIM_Ohio]

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%.

Good point, I went back and read

We both max our 401Ks at $15.5K per year. I receive a 7% employer match and my wife receives a 4% match.

It appears OP meets the 15% savings guideline recomended by many investment professionals (T Rowe Price is where I get my savings suggestions from).

Other advice above is still quite accurate (need to formulate goals and risk tolerance).

[LivingAlmostLarge]

I have no issues with your debt either house or student loans. I have a mortgage similar to yours and student debt, but not as much.

I already mentioned the ROI of your student loans seems quite hefty considering you are making $210/year at 31. That's nothing to sniff at and will likely go higher.

I think the problem is people think only get rid of debt. Good, but you are in an income where you need to consider lowering taxable income because it saves you more like myself and Jim have pointed out.

Another thing is what's done is done. More than buying an expensive house (which I also have), is not having kids. BUT realistically who does that?

You and I both know your mortgage savings is minimal when compared to your daycare costs. But heck you are doing fine as long as you keep on track to not start spending more.

So my vote is buffer ef, then look at debt repayment.

[JinCO]

jIM_Ohio - thanks for your post. I like the idea of the forecasting analysis that you have proposed. I put together a net worth model last week based on our current assets/debt/spending/savings plan. I think it would make a lot of sense to put together a few different "what if" scenarios by modifying the amount of money that went towards paying debt vs. investing. The one thing I always strugle with is what number to use a projected growth rate. I am currently forecasting a growth rate of 6% in my 401Ks, but I have read that people use 8% - 10% or higher in a lot of cases.

I also agree that we need to factor in some of our mid-term financial goals. We receive bonuses in Aug and Sept. so my plan is to use this to build up or emergency fund. We also need to factor in car expenses and savings for my daughter's education.

You are correct in assuming that my ultimate goal is not to pay off all of the debt as soon as possible if this will result in less net worth long term. I should have been more specific in my post.

One correction to your post - we are actually each putting in $15.5 annually towards 401K so $31K total. I would like to increase this number over time, but will probably keep this as our primary retirement savings vehicle over the next 3 years as we try to reduce our debt load.

[jIM_Ohio]

jIM_Ohio - thanks for your post. I like the idea of the forecasting analysis that you have proposed. I put together a net worth model last week based on our current assets/debt/spending/savings plan. I think it would make a lot of sense to put together a few different "what if" scenarios by modifying the amount of money that went towards paying debt vs. investing. The one thing I always strugle with is what number to use a projected growth rate. I am currently forecasting a growth rate of 6% in my 401Ks, but I have read that people use 8% - 10% or higher in a lot of cases.

I also agree that we need to factor in some of our mid-term financial goals. We receive bonuses in Aug and Sept. so my plan is to use this to build up or emergency fund. We also need to factor in car expenses and savings for my daughter's education.

You are correct in assuming that my ultimate goal is not to pay off all of the debt as soon as possible if this will result in less net worth long term. I should have been more specific in my post.

One correction to your post - we are actually each putting in $15.5 annually towards 401K so $31K total. I would like to increase this number over time, but will probably keep this as our primary retirement savings vehicle over the next 3 years as we try to reduce our debt load.

A good, specific post.

General questions get general answers (3 pages of them so far)
Specific questions should get more specific answers.

8% return for planning in 401k should be minimum. If you are planning (investing) in such a way to get 6% return, I would pay down the debt before accepting a 6% return.

In a taxable account, 7% return should be acceptable (lose 1% to taxes).

Plan for 8% long term and track this- so you know if you are getting the same return as your investments. If mutual fund reported an 11% yearly return and you only calculated 8%, there is an inefficiency you need to track and possibly fix.

In general, investing will beat paying off debt like yours every time. Investing for a 7-8% return while borrowing money at 3-4-5% rates is a net gain of 2% (7%-5%=2%).

This is leverage working for you.

Your risks with leverage would include losing a job, so make sure you hedge this risk with an emergency fund of around 12 months worth of expenses.

[JinCO]

LivingAlmostLarge- yes, waiting for children would have helped our current situation but I'm not sure that it would have helped our long term situation. If we waited we could have paid off more debt and been in a better financial situation at this point. On the other hand, my wife plans to continue working and her job will likely become more demanding as time goes on which would make it harder to balance working with time off for pregnancy, maternity leave, etc.

My question for you is why debt repayment vs. investing in something that would yield a higher return. $52K of our student loans are scheduled to drop to a rate of 2.65% next year. It seems to me that at some point it becomes a numbers game. Why should I spend $20K / year towards debt that is growing at a rate lower than inflation instead of investing in something I could be earning 6% - 8% on? I am planning on putting together some 'what if' analysis based on the suggestion of jIM_OHIO to understand my options better.

[JinCO]

jIM_OHIO - the 6% number was just used in my model, not based on actuals. I was trying to be conservative when forecasting but I will move it to 8% for now and track the results.

12 months seems like a pretty hefty emergency fund. We do have some levers to work with if one of us lost our jobs. $2600 in child care costs would go away right of the bat. We could also reduce / eliminate $401K investing. We could also reduce "overpaying" our mortgage and HELOC. Student Loans could be deferred. The bottom line is that we could live off of one salary if we needed to.

If both of us were to lose our jobs at the same time, we would have about 6 months to find new jobs based on severence, unemployment and current savings. I understand that the concept of the EF is planning for worst case scenarios, but shouldn't you also factor in the liklihood of the emergencies occuring. I would think you would want to carry a higher EF if you were relying on one income because there is a single point of failure or if you felt there was a risk of losing your job.

[tripods68]

JinCO,

ROI 6% or 8% is not enough to WOW me to not pay off my student loan sooner. For one, how bout if you lose your job? Second, factor in the inflation rate today 4% substract 8% ROI = NET ROI is only 4% (less expense ratio) Versus paying 2.65% student loan next year. Not much there to be excited about. Is it worth it to pay off student loan knowing you no longer have interest cost to carry versus netting 1% or 2% ROI adjusted for inflation. Unless, you can guarantee a 12% ROI we all know that's not how the market works. Again, past performances does not guarantee future returns. Sorry, but I'm for paying off student loans.

[JinCO]

tripods68 - thanks for your post. Paying off the student loans does seem like the general consensus. I still want to model it out to see what the numbers say.

[Scanner]

Tripod,

Student loans have forebearance and deferment for job loss and disability.

You also seem to apply the inflationary number 4% to the ROI on the 401(k) but not apply it to the student loan.

If he's paying 2.65% on the student loan and there is 4% inflation, hell, that's great, right?

His student loan balance is just getting smaller by looking at it with high inflation. He's got cheap money.

We could argue about 6, 8 or 10%. . . I personally think the stock market will stall at 0% the next 5 years until we are able to get on an alternative energy source in America. Once that happens, there will probably be a run-up. to catch up to 6-8%.

[tripods68]

JinCo,

I'm glad you agree. You actually have a bigger problem that lies ahead aside paying off your student loans. How best to reduced future tax liabilities at your current income. Tax thing is not my forte. But i have many friends started investing in rental properties just to avoid paying too much taxes.

Good luck

[tripods68]

Scanner,

This is a matter of preferance. As I said, 4% versus paying 2.65% student loans DOES not get me excited at. Maybe to you. More importantly, I preferred not having any student loan payments if I have JinCO's income.

[noppenbd]

Scanner,

This is a matter of preferance. As I said, 4% versus paying 2.65% student loans DOES not get me excited at. Maybe to you. More importantly, I preferred not having any student loan payments if I have JinCO's income.

You are not comparing apples to apples. 4% ROI after inflation should be compared to student loans after inflation... if inflation is 4%, then student loan effective interest rate is negative 1.35%!

[jIM_Ohio]

jIM_OHIO - the 6% number was just used in my model, not based on actuals. I was trying to be conservative when forecasting but I will move it to 8% for now and track the results.

12 months seems like a pretty hefty emergency fund. We do have some levers to work with if one of us lost our jobs. $2600 in child care costs would go away right of the bat. We could also reduce / eliminate $401K investing. We could also reduce "overpaying" our mortgage and HELOC. Student Loans could be deferred. The bottom line is that we could live off of one salary if we needed to.

If both of us were to lose our jobs at the same time, we would have about 6 months to find new jobs based on severence, unemployment and current savings. I understand that the concept of the EF is planning for worst case scenarios, but shouldn't you also factor in the liklihood of the emergencies occuring. I would think you would want to carry a higher EF if you were relying on one income because there is a single point of failure or if you felt there was a risk of losing your job.

I tier my EF into 2 layers.

The first layer is the cash layer. I have 3 months expenses in CDs. Three 90 day CDs, each CD maturing 30 days from the previous or 30 days before the next one.

The second layer is the stability layer (for mid term expenses, emergencies and similar). I invest this in PRPFX, which has double/triple the return of the CDs, and the risk profile of the investment suggests it will rarely lose money (year over year).

The second layer for me is also where deposits go for the following:

1) kids college savings
2) new car fund
3) any mid term expense such as a vacation in 3 years, new roof, or similar.

I might suggest you tier your EF to be the following:

1) calculate one months expenses if a spouse was NOT working. Set aside 3 months of this value in a cash based investment.

2) set aside months 4-12 of the same number in a more growth oriented investment.

3) set aside an additional amount based on two spouses not working (maybe 3 months total expenses).

Logic being:
Cutting back is a way to make 3 months expenses become 6 months. It is not how I would plan to handle a short term problem. What if your child gets sick and both spouses need to leave work for a short amount of time? What if spouse A gets sick and spouse 2 loses job? If you planned on cutting back to get budget in line with income, you are living "paycheck to paycheck". If you have cash set aside, the cutting back just allows that cash to go further.

In an emergency, cash is king. Cutting back is overrated and means you have not saved enough.

I am never surprised when this board blindly recomends to pay off debt... but I think in your case most people do not see the tax situation here. Your income suggests a tax plan is more important than a managing debt plan. Good thing the board's advice is free. That tax plan will probably suggest keeping debt (such as a mortgage) where you can write off a portion of the interest. You could probably also create your own business (of some sort) to get even more writeoffs. The tax plan will save you more than the interest you pay every year in student loans.

When doing the planning (projections) of net worth, you need to have an end goal in mind. Might be the day your child goes to college, might be the day both spouses can retire, might be the day a research project ends. That end goal is where
a) you need to know net worth
b) you need to know value of investments
c) you need to know how much debt you still have
d) you need to know monthly expenses

I would then work backwards. Are the expenses you have today close to the expenses you will have at that date?

What would it take to have debt paid off by that debt? If date is far enough out, the debt might go away quietly on it's own. If date is real soon, the debt needs to be paid off aggressively.

If the investments do not cover the expenses, you need to adjust the debt pay down previously to make sure an 8% (or x%) growth rate gets the needed investment balance.

If the net worth covers the expenses (but investments do not), consider reallocating the debt payoff structure (similar to previous step) to make sure you have liquid cash to cover real expenses.

Because there are so many unknowns when doing this, you need to be conservative in some ways, optimistic in others, and plan for many situations.

For example: what if you invested instead of paying down the debt. If your total debt load is 800k (500k house, 300k student loans), maybe you invest until you have enough set aside to pay off the debt. Then once you have the debt balance set aside (so net worth is zero), start paying off the debt. letting the money which had been set aside keep growing.

In this case you kept liquid funds when risk was high (high debt is high risk). Once you crossed the point where you are worth more than your debt, you pay off the debt to lower your risk, while you still have the liquidity to solve other problems if needed.

This is my plan (for me) more or less. Keep cash on hand growing faster than my debt. Once I can pay off my $325k mortgage with cash on hand, I will stop setting aside extra payments in an investment, and start making real extra payments to the debt. I keep my liquidity (which is my primary goal when dealing with debt), while also working towards time timeline which has me retiring the year my oldest graduates college (57) or high school (53).

[disneysteve]

It seems like a lot of the posts are saying that we have been financially irresponsible by accumulating so much debt.

Some people think all debt is bad. Others don't.

Having graduated professional school with 6-figure student loans, I'd have to say I'm one who doesn't see a problem with taking on debt that serves a good purpose and that you will have the means to repay in a reasonable amount of time.

When I was first out of school, and for quite a few years after that, we lived pretty lean and frugal. My loans had a 25-year repayment schedule. I paid them off in 12 (and it would have been 10 had I not changed jobs and been unemployed for a few months along the way).

Med school isn't something you can do part-time, online or through night school. It is all or nothing. Without the loans, it wouldn't have happened, so I've got no regrets at all.

Just wanted to throw in that opinion.

[tripods68]

I stand corrected noppenbd