Pay off low-interest student loan (2.875%)?

[Rrolack]

My wife has a student loan of 2.875% This is a great rate, and I was originally not inclined to pay off the loan.

However, our income is high enough that the interest is non-tax-deductible, and this will likely be the case every year from here out. So in that sense, the rate is not as low at it looks.

I'll also mention that we have taxable bonds in fully taxable accounts. This is because our retirement accounts only have so much room, and with the bond allocation we want, our bonds would be 75% munis if we refused to hold taxable bonds in taxable accounts. I'm not comfortable with a 75% muni allocation, so there isn't much choice other than taxable bonds in taxable accounts.

One of the funds we hold in taxable is the Long-Term Treasury fund, which has a yield of 2.7% (before tax). On the face of it, selling this fund to pay off the student loans looks good.


Given all of the info above, any thoughts on whether we should pay off or not pay off the loan?

[G-Money]

A few considerations:

1. Liquidity. If you pour the money from a bond fund into your savings account, is there any chance you'll miss it? If one of your cars die tomorrow, or the roof springs a leak, etc., where would you tap the money for that?

2. Other debt. Obviously, if you have higher interest rate debt, you should be looking to pay that off first.

3. Convert student loan debt into tax deductible debt. If you own a home, regardless of whether you have a mortgage, you could do a cash-out refi. Use the cash-out part to pay off the student loans. You can deduct up to $100,000 in equity that you pull out of your house on top of whatever remains of your purchase-money mortgage. http://www.irs.gov/publications/p936/ar02.html

If you do this, I would recommend going the no-closing cost route. For example, since you were considering just paying off the loan anyway, you could take out a no-closing cost 5 year Home Equity Loan ("HEL") from PenFed at 1.99%. https://www.penfed.org/home-equity-loan ... r-10312012 That would: (1) lower your interest rate significantly and (2) likely (subject to Pub 936) make your interest tax deductible. And a 5 year pay-off is likely a compromise between paying the loan off now or keeping it as long as possible.

Now, if you don't have a house, you can't do a no closing cost refi. Depending on your plans to buy a house in the coming years, that also might argue in favor of keeping the loan and the extra liquidity.

4. What does your wife think? Don't ever underestimate the importance of this consideration.

[Rrolack]

Thanks for the reply G-Money.

The loan amount is under 2% of our net-worth, so we won't miss the liquidity.

No other debt.

We don't own a home, but there is a good chance we will in the next few years. If we bought a home, I assume the interest rate would be well above 2.875%? That said, I realize this interest would be tax-deductible.

My wife has no preference; she's happy to go along with what I think is best here.

[Khanmots]

Few other considerations;

If worse comes to worse student loan debt is not discharagable in bankruptcy.
Also, along the lines of what G-Money said, you could substitute a paid off car for the house and should be able to get a rate of 1.5 to 2% for a 3-5 year loan that way. I think.

Finally, what would make you sleep better? Personally I'm looking forward to the day I'm again debt free. It was a nice feeling before I got this mortgage But... I also like having liquidity, so I'm paying off my mortgage at an accelerated rate, but not as fast as I could, I also have money going into taxable investments that I know I can tap if I *need* to. This balance seems right psychologically for me. What balance of paying loan off earlier as opposed to having more money at hand if it's needed would make it easiest for you to sleep well?

[Khanmots]

We don't own a home, but there is a good chance we will in the next few years. If we bought a home, I assume the interest rate would be well above 2.875%? That said, I realize this interest would be tax-deductible.

Think I just saw someone advertising 3.25% for a 30-year fixed. So if it's tax deductible and the student loan isn't, the student loan is at a higher rate.

Assuming that rates are the same when you do get around to buying a house that is

[Rrolack]

If I don't own a home now, is it right that, even if I wanted to "roll" the student loan into my mortgage, there is no need to hold the student loan until I get the mortgage?

That is to say: I could pay off the student loan now, and get a larger mortgage later than I would have, had I not paid off the loan.

[zebrafish]

Would you take out a fixed 2.875% loan and take that money to go invest in taxable bonds yielding about the same (or less)?

Essentially, this is one way of looking at what you are doing by not paying off the loans.

If you are left with an emergency fund, then I would pay them off.

[Bob's not my name]

2.875% isn't low. My car loan is 1.74%. I can get a 30-year mortgage at under 2% effective after deduction. You've already figured out that taxable bonds can't touch 2.875%.

[G-Money]

The loan amount is under 2% of our net-worth, so we won't miss the liquidity.

This is the key, in my OP. It doesn't matter what you do. The difference in outcomes between paying it off or keeping the loan and investing the difference is a rounding error for you.

If paying it off simplifies your life, then pay it off. If keeping the loan is simpler, then keep it. I wouldn't waste a lot of time or energy worrying about it.

With no home, you could get an auto loan, as Khanmots suggests. PenFed is offering 5 years at 1.49%. Can't deduct the interest, but it cuts your interest rate in about half. But again, see my point above, because saving 1.375% interest in the short term on 2% of your net worth is only going to improve your net worth by about 0.0275%.

We don't own a home, but there is a good chance we will in the next few years.

Having no student loan would increase the amount of a mortgage you could get. Lenders typically look at your total debt-to-income ratio (DTI). Of course, with a relatively small loan, my bet would be that the monthly payment is also a very small fraction of your income. So again, it goes back to my point that it likely makes very little difference for you.

If I don't own a home now, is it right that, even if I wanted to "roll" the student loan into my mortgage, there is no need to hold the student loan until I get the mortgage?

That is to say: I could pay off the student loan now, and get a larger mortgage later than I would have, had I not paid off the loan.

Correct, as long as you don't go over 80% loan-to-value (LTV), you'll be good to go. You might be able to get a slightly better rate/lower closing costs combo if you can get LTV to 60% or less, but the difference between 60% and 61% LTV is peanuts compared to the difference between 80% and 81% LTV.

[market timer]

I would not pay it off at current rates. Comparing student loans with Treasuries is not apples-to-apples. Even ignoring the free life/disability insurance student loans offer, there is valuable optionality with student loans that is worth considering. Some people think of loans as negative bonds, which I agree with. However, unlike being short Treasury bonds, the (negative) value of student loans cannot increase beyond today's payoff value. That is, such loans are like being short Treasuries with a free call option. Paying off the loan gives up this free call option.

Also, you note holding taxable bonds. Are you maxing out your annual purchases of I bonds ($15K/person) and EE bonds ($10K/person)?

[zebrafish]

I would not pay it off at current rates. Comparing student loans with Treasuries is not apples-to-apples.

If you are investing money in bonds that could be used to pay off loans immediately, then how is this not apples-to-apples?

If I-bonds yield ~2.2% and the interest rate on the student loan is ~2.8%, you are essentially losing money by investing a given amount of dollars in I-bonds that could be used to pay off the loan, no?

[G-Money]

I would not pay it off at current rates. Comparing student loans with Treasuries is not apples-to-apples.

If you are investing money in bonds that could be used to pay off loans immediately, then how is this not apples-to-apples?

Because the Treasury has no call option. If interest rates plummet, the Treasury can't buy back your now-higher-than-market-rate bonds. It's stuck paying you the higher coupon rate. You, on the other hand, have the option to prepay your mortgage. All else equal (such as term, credit quality), a callable bond needs to pay a higher rate of interest than a non-callable bond to compensate the lender for the call risk.

If I-bonds yield ~2.2% and the interest rate on the student loan is ~2.8%, you are essentially losing money by investing a given amount of dollars in I-bonds that could be used to pay off the loan, no?

I bonds only pay 2.2% for 6 months. Then they'll pay whatever the next semi-annual calculation of inflation is. Could be higher, could be lower. The better comparison would be a Treasury bond of equal duration (to make term and credit risk equal). Then add the value of the call option (don't ask me how, I don't know).

[market timer]

If I-bonds yield ~2.2% and the interest rate on the student loan is ~2.8%, you are essentially losing money by investing a given amount of dollars in I-bonds that could be used to pay off the loan, no?

Not if I buy $x of I bonds, buy $x of long term Treasuries, borrow $x at 3-month Libor, and sell a call on long term Treasuries. Then I'm picking up portable alpha from the student loans and the I bonds. Note there are two arbitrage pairs here: (1) student loans vs. Treasuries + call, (2) I bonds vs. Libor. If Libor rises above I bond rates, I can redeem the I bonds. If long term rates fall so low that Treasuries + call premium does not cover student loan interest, I can prepay student loans.

[zebrafish]

I bonds only pay 2.2% for 6 months. Then they'll pay whatever the next semi-annual calculation of inflation is. Could be higher, could be lower.

Sure, this is true. And, I would say it is like comparing Fuji apples to Braeburn apples. To me, they're pretty alike. To you, they're perhaps different. Right now, I still argue that this is a bad deal to keep the loan. Only if you think interest rates will go up significantly AND you want to keep this loan hanging around for whatever that term of waiting may be that it will take for interest rates to rise, does this lead to a net payoff. Each day you wait, you have to wait longer because you're in the hole based on rate comparisons today.

I thought Bogleheads liked simplicity? To me, it is simpler (and less stressful) to have a net worth with the least amount of liabilities possible...

[zebrafish]

If I-bonds yield ~2.2% and the interest rate on the student loan is ~2.8%, you are essentially losing money by investing a given amount of dollars in I-bonds that could be used to pay off the loan, no?

Not if I buy $x of I bonds, buy $x of long term Treasuries, borrow $x at 3-month Libor, and sell a call on long term Treasuries. Then I'm picking up portable alpha from the student loans and the I bonds. Note there are two arbitrage pairs here: (1) student loans vs. Treasuries + call, (2) I bonds vs. Libor. If Libor rises above I bond rates, I can redeem the I bonds. If long term rates fall so low that Treasuries + call premium does not cover student loan interest, I can prepay student loans.

Ok, I'll have to go get my MBA and get back to you on this one

It seems like a lot of shenanigans/effort to earn a pretty small return differential...

[G-Money]

I bonds only pay 2.2% for 6 months. Then they'll pay whatever the next semi-annual calculation of inflation is. Could be higher, could be lower.

Sure, this is true. And, I would say it is like comparing Fuji apples to Braeburn apples. To me, they're pretty alike. To you, they're perhaps different. Right now, I still argue that this is a bad deal to keep the loan. Only if you think interest rates will go up significantly AND you want to keep this loan hanging around for whatever that term of waiting may be that it will take for interest rates to rise, does this lead to a net payoff. Each day you wait, you have to wait longer because you're in the hole based on rate comparisons today.

I thought Bogleheads liked simplicity? To me, it is simpler (and less stressful) to have a net worth with the least amount of liabilities possible...

As for deciding which fruits we're comparing, I'd look at the difference in performance each year between TIPS and nominal Treasuries. A bond that tracks CPI is a different animal than a fixed rate bond.

There can be good reasons for keeping the loan (even at higher cost), such as need for increased liquidity. Also, the call option is worth *something* even if it is harder to calculate. As I already pointed out for the OP, the incremental difference in final outcome between the two choices is so small that it makes virtually no difference.

As for simplicity, some people have their student loans on autopay and their paychecks direct deposited at Vanguard. It might literally be simpler to do nothing than to pay off the loan. Different strokes . . .

[RenoJay]

I'd pay it off. We are in a sort of similar position, and I just paid off my wife's student loans (that had a similar interest rate) and I feel fine with the decision.

[NightOwl]

Given all of the info above, any thoughts on whether we should pay off or not pay off the loan?

I don't have anything to say on the question of "should" (assuming you are maxing all available tax-advantaged space and maintaining liquidity), but I can tell you that I recently chose to pay off a 3.1% fixed-rate student loan. To minimize potential regret, at the end of every month I invested half of all available money and paid down the loan balance with the other half. That basically guarantees that I didn't act optimally, but it also likely makes any mistake a fairly small one.

My loan balance was significantly more than 2% of my net worth -- in your situation at 2% of nw, I'd pay off the loan from existing funds without hesitation. Just because it's a low percentage of your net worth doesn't mean you aren't making a theoretical mistake, but it does mean that the consequences will be fairly minor.

I am not much influenced in this matter by any feelings of peace of mind -- nothing I care to do in this life will render me free of bills coming due every month -- but getting rid of an account on my Yodlee screen? That's worth something to me.

NightOwl

[Rrolack]

Thanks for the advice guys. With everything said, I'm leaning toward paying off the loan.

While it sounds like there is some lost optionality to doing this, the mental distraction of continuing to weigh the pay-off vs. don't-pay-off decision into the future, monitoring bond rates, etc. doesn't seem worthwhile given the size of the opportunity. I'm too busy with other things to want to actively manage this.

If it were 25% of my net worth, it might be a different story (and liquidity concerns would be more paramount).

[retiredjg]

The elephant in the room, at least for me, is why 75% of your bonds need to be in your taxable account. This seems a bit out of whack to me (unless an inheritance has shifted things that direction).

You didn't ask about that and certainly don't need to comment on it, but I think you should consider if you are making optimal use of all the tax-advantaged space available to you. And have you considered I bonds (which would be held in taxable, but tax-deferred until cashed in)?

[Rrolack]

retiredjg,

My tax-advantaged space is 100% bonds, and I've been maxing out 401(k) contributions since my career started, so I don't think I can do too much better here. My allocation is also more conservative than most for my age, in part because I'm in a volatile industry, where that volatility is correlated with equity markets.

I do not currently invest in I-Bonds, but I will look into them for sure.

[G-Money]

You didn't mention IRAs, so I'll assume you make to much for Roth or deductible IRAs. Perhaps you're already doing it, but you and your wife can still make non deductible IRA contributions and immediately convert to Roths to gain extra tax sheltered space. http://www.bogleheads.org/wiki/Non-dedu ... oth_IRA.3F

[market timer]

Ok, I'll have to go get my MBA and get back to you on this one

It seems like a lot of shenanigans/effort to earn a pretty small return differential...

Well, it isn't necessary to perform the arbitrage, as long as one understands that the optionality is there. One may be willing to pay an extra 0.5-1%, after-tax, for the call option.

I've actually been employing this exact arbitrage (savings bonds and student loans vs. Treasuries) for four years now. By my estimate, at today's rates, the fair market value of I bonds would be 10-15% higher than the purchase price. For EE bonds, the fair market value would be 15-20% higher than the purchase price. This is before factoring in tax advantages--deferred interest, tax free for education. If you have the means, not buying the full allotment of these bonds is leaving thousands of dollars on the table every year.

[retiredjg]

retiredjg,

My tax-advantaged space is 100% bonds, and I've been maxing out 401(k) contributions since my career started, so I don't think I can do too much better here. My allocation is also more conservative than most for my age, in part because I'm in a volatile industry, where that volatility is correlated with equity markets.

I do not currently invest in I-Bonds, but I will look into them for sure.

1) You don't mention IRAs, so I'll just guess you can't deduct contributions for tIRA. But if you are in need of bond space, you might use non-deductible contributions to tIRA. But wait...there might be a better choice....

2) Since you don't mention Roth IRA either, are you aware that many people can contribute to Roth IRA through a "back door"?

http://thefinancebuff.com/the-backdoor- ... ow-to.html

And even if you are not a good candidate, your spouse might be.

I would not want 75% of my bonds in a muni bond fund either, so if you can find more tax-advantaged space, it could be a good thing. I Bonds will only be a fix for $10k per person per year (another $5k if you want to use a tax return to buy them).

Have you considered CD's for part of this fixed income allocation? It's pretty easy to hold CDs in a taxable account.

What about a Health Savings Account (HSA)? (has to be available through your work if I understand correctly)