If you had a windfall, would you pay off a loan with 2.5% in

[mildred66]

Hi all,

I'm getting a windfall next year that would pay off all my student loans, which are at 2.5% interest. I've heard arguments that this rate is so low, I should pay it off as slowly as possible (e.g., inflation), and invest the windfall somewhere else.

I've read through the Paying_down_loans_versus_investing wiki article, but would like to hear from you guys.

Note that my loan interest is likely not tax deductible this year.

[chipperd]

For my situation, I would vote yes but would have to answer these questions first: are the amounts the same? tax implications (do you get to write off interest paid on student loan)? How this loan/windfall fit into the rest of your portfolio?

[Bob's not my name]

answer these questions first: do you get to write off interest paid on student loan?

Answered before asked.

[livesoft]

I would invest the money for sure. When my return on investment was +10% or so, I would consider paying off the loan then. If my ROI became -10%, I would just wait until it was +10% before using it to pay off the loan.

[Khanmots]

How much do you personally value liquidity?
How much do you personally dislike debt?

And questions for us... are you taking advantage of all available tax-advantaged space now, and what size is your EF?

[sscritic]

It might depend on what else I had. If I had student loans of $200,000 and $300,000 invested in a taxable account and had another $300,000 come in over the transom, I might pay off the student loans and keep only $400,000 invested. But I voted keep the loan.

[BBL]

Not enough info to say.

1M windfall, 10K debt - pay it off to get rid of it.
10K windfall, 10K debt - ???? other factors matter
100K windfall, 50K debt - probably not

Other qualitative factors at play here too.

by Khanmots » Sat Dec 22, 2012 9:04 am

How much do you personally value liquidity?
How much do you personally dislike debt?

And questions for us... are you taking advantage of all available tax-advantaged space now, and what size is your EF?

[Call_Me_Op]

Student loan debt is the worst-type, as it cannot be discharged. I'd get rid of it.

[stevewolfe]

I'd pay off the loan. I've never regretted paying off debt early (or saving to buy something instead of having the debt in the first place...).

[Default User BR]

Assuming it's fixed rate, I would not pay it off early.


Brian

[Rodc]

To my mind the biggest missing piece of information is what sort of emergency fund do you have. If that is not in place or not sufficient I would address that first.

[Bob's not my name]

To my mind the biggest missing piece of information is what sort of emergency fund do you have.

Emergency funds: 3-6 Months (in i-bonds and ING Direct)

Portfolio Size: Low six-figures.

Taxable
20.4% Fidelity Spartan Total Market Index Inv (FSGUX) (Expense Ratio (ER): 0.24%)
16.3% Spartan Global Ex US Index FD Investor Cl (FSTMX) (ER: 0.10%)
10.3% Yacktman Fund (YACKX) (ER: 0.80%)

[Watty]

If you invest the money then withdrawal enough from your investments each month to pay the student loan, then you will have dollar cost averaging working against you.

I would pay it off but then save the money each month that you would have used to pay the student loans. This way dollar cost averaging will be working for you.

I don't know what the numbers are but keeping the loan might work out well a high percentage of the time but there will always be some small percentage of the time that it will work out badly.

[southwest_stacker]

It is hard to describe how being 100% debt free feels. There is no math to describe it. We have always been smart with debt and did ok but once we paid everything off it was like life changed. It is hard to describe but it is definitely worth it. It is amazing how fast you can build up money once you have zero payments.

[southwest_stacker]

The other thing I will add is the 2.5% you pay on your debt is guaranteed.You WILL pay that. What you earn on your investments is a crap shoot. You might make ten percent you might lose ten percent. Using this example if your investments gain you will feel smart making the 7.5% spread but if they lose you will feel pretty dumb losing 12.5%.

[sscritic]

It is hard to describe how being 100% debt free feels. There is no math to describe it. We have always been smart with debt and did ok but once we paid everything off it was like life changed. It is hard to describe but it is definitely worth it. It is amazing how fast you can build up money once you have zero payments.

Did you scream at Dave Ramsey? I didn't. I had a house with a mortgage. I sold it. It didn't feel any different; the only thing that changed in my life is that I didn't have to cut the grass anymore. I'm glad it had a big psychological impact on you, but it didn't on me. Everyone is different.

[sscritic]

More on feelings: I had cash; I bought a house; I could have bought it with my cash; instead I got a mortgage so I could keep my cash. Why? Because I felt better having cash and a mortgage than having no cash and no mortgage. Having no cash and no mortgage just didn't feel right. So you are right; it's not math, it's feelings. It's just that some of us feel differently.

P.S. No cash does not literally mean no cash; it means less cash.

[southwest_stacker]

Has nothing to do with Dave Ramsey. I don't even agree with a lot he says.

Maybe for me it is because I am self employed. I was always stressed about how I had to pay the mortgage, pay the student loan, etc. I often would take on projects with my business that I knew were not very profitable just because I felt I needed every penny to meet my obligations. I made lots of decisions based on need or fear.

Now I bid on the jobs I want and don't sweat the ones that I don't like. It is such a stress relief for me. I have no payments and I have enough money in the bank that if I didn't work for a year or more I would be ok because my expenses are so low.

[grabiner]

I'm getting a windfall next year that would pay off all my student loans, which are at 2.5% interest. I've heard arguments that this rate is so low, I should pay it off as slowly as possible (e.g., inflation), and invest the windfall somewhere else.

I would suggest paying it off even if the loan is fixed; 2.5% is not low in today's context.

You will probably invest some of that windfall in bonds, and since the windfall is more than you can contribute to your 401(k), you will have some taxable investments. It doesn't make sense to borrow money at 2.5% so that you can lend it at 2.19% with risk (current yield on CA Long-Term Tax-Exempt Admiral Shares).

Your marginal tax rate is 35% (28% federal, 9.3% CA tax deductible from federal), so if you buy a house and decide to take out a mortgage at 4%, that will be only 2.8% after tax; even if the student loans are fixed, you aren't losing much by paying them off early.

[Toons]

Pay It Off

[nedsaid]

When I graduated from college, I had an NDSL loan at 4%. I paid it off early.

I paid it off because I wanted to be debt free and I wanted the funds freed up so that the University could lend it to other students.

In retrospect, I probably should have paid it on schedule rather than early. I would not pay off a 2.5% loan early. I am a big believer in liquidity. In an emergency, you need access to good old fashioned money in the bank. The money used to pay a 2.5% loan off early will not be available to you in an emergency.

[nedsaid]

I like what financial planner Jonathan Pond says. Financial decisions do not have to be all or nothing.

You could do some of both. Pay the principle down but not in full. Put some money in the bank.

[Default User BR]

It is hard to describe how being 100% debt free feels.

For me, it felt no different than having debt.


Brian

[Default User BR]

The other thing I will add is the 2.5% you pay on your debt is guaranteed.You WILL pay that. What you earn on your investments is a crap shoot. You might make ten percent you might lose ten percent.

You can say the same about any guaranteed return. Under your theory, one should NEVER invest in the stock market or bonds unless held individually and to maturity. After all, a CD is guaranteed return, and the other investments a crap shoot.


Brian

[bsteiner]

There's an option value in not paying off the loan. In other words, you can pay it off at any time, but if you need the liquidity later on, you may not be able to borrow it back. Given the interest rate of 2.5% (even if not deductible), there may be a net benefit to not paying off the loan. Even if the interest you pay isn't deductible, depending on how you invest the money, the additional investment income and gains may not be currently taxable as ordinary income.

In determing your asset allocation, keep in mind that the loan is the equivalent of being short a bond.

[Default User BR]

In determing your asset allocation, keep in mind that the loan is the equivalent of being short a bond.

I disagree with this. The loan should not be considered part of the asset allocation at all.


Brian

[southwest_stacker]

One fallacy I see is everyone assumes if you pay of your debt you will be broke and have zero cash. That wouldn't be smart. You need an emergency fund and good cash buffer. Don't pay off all of your debt if it leaves you penniless. I am saying I think it is not smart to paying interest on a loan when you have ample money to pay it off and still have enough cash for emergencies.

Ultimately it is a matter of personal preference. Leverage can make you money or it can make you bankrupt. It all depends on your tolerance for risk. Me personally I am more concerned about preserving what I have than playing games and risking it trying to make more.

[mildred66]

Thanks for all the thoughtful responses everyone! Really helpful.

[yukonjack]

I'm in a similar situation. So to have a little fun with it my plan is to invest the money if we go off the financial cliff and the market craters. And if the fiscal cliff is averted and the market goes up I'll payoff my loan and resume normal investing. In my situation the investing is in a taxable account.

[Dandy]

Of course a lot depends on your financial situation and how much the windfall is compared to the debt. If you are in reasonably good financial shape I would pay off the debt. Clear the decks and free up monthly money to invest along with the remainder of your windfall.

[Bud]

Would you borrow money at 2.5% interest to invest? If not, pay off the loan.

[skyvue]

Thanks for all the thoughtful responses everyone! Really helpful.

I would pay the loan off. The feeling of being totally "debt-free" was something I thought I would enjoy but it is a much better than I ever thought it would be. As others indicate, it is hard to describe the sense of peace and comfort from knowing you do not owe anybody anything. For instance, even a job loss would not be a big deal to me anymore.

[Neal]

I had a similar situation about a year ago with a windfall, and student loans/mortgage debt at low interest in the 2-3% range. I agonized, I feel unnecessarily in retrospect, over the decision of whether to pay off the debt or invest. In the end I had a grand compromise with myself and split the money about 50/50 between investing and the debt. Now as I have extra money, I invest half and use the other half to pay down debt.

I have no particular fear or hate of debt, but I also know there are no "guaranteed" investments out there these days that earn 3%, which is essentially what paying off a 3% loan amounts to (minus the tax advantages, of course)

[MP173]

I am facing this as we speak. Will be closing (selling) a house (was a rental) on New Years Eve. The house is paid off, thus no debt on that property. What to do with the $$$.

My plan:

1. Pay off existing mortgage.
2. Fund 2012 and 2013 Roths for both my wife and I.
3. New master bathroom (Christmas for my wife).
4. Pay off car loans.
5. Invest balance, possibly in gold as I have no such holding.

Debt free is a great feeling, having experienced it a few years ago for a year.

Full disclosure...

I am a commission sales rep and have variable income. My son will be starting college in August/Sept 2013. While he has been offered several full scholarships covering all costs, I still want to be debt free in order to cover college if necessary.

Ed

[leonard]

Assuming this is a life changing windfall - I would pay off the debt and eliminate one more distraction in life. Each debt requires paying, monitoring that payment was receive, and then potential tax complications. Pay it off and have one less headache. Again, this is assuming that the windfall is huge, life changing, especially in relation to the size of the debt being paid off.