Which debt to pay down first?

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EnjoyIt
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Which debt to pay down first?

Post by EnjoyIt » Sun Feb 25, 2018 5:13 pm

For most of my investing life I have always been fine with low interest rate debt and investing everything else. So far it has done very well for us. But now that we are very close to having 25x and about to go part time, I am starting to feel the urge to knock at the debt a little. Not aggressively, but a little extra here and there. What would you do? Please share your reasoning.

School loan:
Debt: ~$90k
Rate: 1.5%
Payment: ~$590/month
Payoff date: Mid 2032

Mortgage:
Debt: $235k
Rate: 2.75%
Payment: ~2400/month
Payoff date: Mid 2027
We itemize deductions every other year by grouping all itemizable expenses every other year including property tax.

I am in my 40s and looking to go part time within about a year which is starting to make me think debt free sooner may be worth the lost potential arbitrage of investing in a taxable account. I think I am ok paying for the luxury of being debt free. Part time income should be enough to still max out 401k, backdoor Roth, and HSA. Part time work is very very reliable. Kids education is covered. I'm not sure how long we will go part time. Definitely until we have 27x plus debt in investments or 27x and debt paid off.

Option 1: Pay down school debt so that both payoff dates are about the same time. Then, pay down each debt equally keeping the payoff dates similar.
Option 2: Pay down school debt till it is completely paid off because it is the smaller debt and will be quicker.
Option 3: Pay down mortgage because it is at a higher rate and will give me best bang for my dollar.
Option 4: Stop this nonsense and just keep investing in taxable.


EDIT: I did some math to calculate the opportunity cost in paying down an extra $2k/month in the mortgage and an extra $1k/month in the school loans vs investing the money over the length of the loan. Once the debt was paid off I then used the now extra cashflow to start investing for what would've been the length of the loan. I ran the calculation using a return of 3%, 4%, 5%, 6% and 7%. Below is the opportunity cost.

Mortgage after 9.5 years.
3% - $4.5k
4% - $12k
5% - $20k
6% - $29k
7% - $38.5k

School loan after 13.5 years
3% - $9k
4% - $15.5k
5% - $23k
6% - $32k
7% - $42k
Last edited by EnjoyIt on Mon Feb 26, 2018 1:45 am, edited 1 time in total.

sport
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Re: Which debt to pay down first?

Post by sport » Sun Feb 25, 2018 5:21 pm

You can get better rates than that with CDs. There is really no reason to pay off low rate debt. As long as you have the money to pay it off any time you want to, there is no risk involved with the debt. So, Option 4.

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EnjoyIt
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Re: Which debt to pay down first?

Post by EnjoyIt » Sun Feb 25, 2018 5:24 pm

sport wrote:
Sun Feb 25, 2018 5:21 pm
You can get better rates than that with CDs. There is really no reason to pay off low rate debt. As long as you have the money to pay it off any time you want to, there is no risk involved with the debt. So, Option 4.
What if I don't "need" the slightly higher return and wiling to pay for the luxury of being debt free?

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Toons
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Re: Which debt to pay down first?

Post by Toons » Sun Feb 25, 2018 5:27 pm

One at a time.
Smallest first.
Start with the school loan.
Every penny you can come up with.






:idea: :idea:
"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee

N10sive
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Re: Which debt to pay down first?

Post by N10sive » Sun Feb 25, 2018 5:29 pm

What would be your income vs debt payments per month part-time?

If you can afford it and still contribute to your retirement accounts option 4 seems fine. The interest rate is low enough.

Unless you want to get rid of the little interest on the student loan which I presume is not deductible in any way then you could pay that down somewhat to reduce the interest. This would probably be the best as you can't write it off.

jucor
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Re: Which debt to pay down first?

Post by jucor » Sun Feb 25, 2018 5:34 pm

Several questions:

1) Is your 25x expenses in investments exclusive of your debt?
2) If you delayed going part time how many years of the higher income would it take to pay down your debt if you dedicated the difference solely to that?
3) Is your biannual exemption bundling still going to work with the doubling of the standard deduction?


Absent other considerations, I'd likely start paying down the higher interest debt first.

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JoeRetire
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Re: Which debt to pay down first?

Post by JoeRetire » Sun Feb 25, 2018 5:36 pm

EnjoyIt wrote:
Sun Feb 25, 2018 5:13 pm
But now that we are very close to having 25x and about to go part time, I am starting to feel the urge to knock at the debt a little.

Option 4: Stop this nonsense and just keep investing in taxable.
This is what I would do.
I don't understand the sudden urge to change your philosophy after all these years. I don't see what 25x has to do with it. I don't see what part time has to do with it.

Fight the urge - you know better!
:D
I think I am ok paying for the luxury of being debt free.
Or do this if it helps you sleep at night.
I don't understand it, but it's your money and we all have the luxury of spending our money the way we choose - even if it goes against our financial philosophies.
Which debt to pay down first?
If you truly must pay down one of the two and only one - choose the one with the higher effective interest rate, always.
Unless you will sleep better by paying down the other one for some unknown reason.
Last edited by JoeRetire on Sun Feb 25, 2018 5:45 pm, edited 2 times in total.
Very Stable Genius

inbox788
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Re: Which debt to pay down first?

Post by inbox788 » Sun Feb 25, 2018 5:41 pm

EnjoyIt wrote:
Sun Feb 25, 2018 5:13 pm
Option 3: Pay down mortgage because it is at a higher rate and will give me best bang for my dollar.
Option 4: Stop this nonsense and just keep investing in taxable.
I'd be choosing between these two. I feel foolish paying off a lower interest loan when there's a benefit by paying off a higher interest loan first. Put the low interest loan (student loan) on automatic minimum payment and live with it. I might even do that with a mortgage at 2.75%, especially if it's tax deductible, so effective interest is likely to be less than 2%. If it's not deductible, then it's close and paying it off may be advantageous, especially if you adjust elsewhere, like being more aggressive with your investments, which you can afford to because you're carrying less loans or no loans.

Compound
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Re: Which debt to pay down first?

Post by Compound » Sun Feb 25, 2018 5:45 pm

No bad choices here.

Some additional information would help narrow the choices. How much money do you plan to use for debt reduction or to put into taxable accounts each month? Will you be itemizing your taxes with the changes in tax law? If so, what is the effective mortgage rate after tax deduction? How much do you dislike the debt?

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Re: Which debt to pay down first?

Post by ThriftyPhD » Sun Feb 25, 2018 6:11 pm

Financially, paying off the student loans wouldn't make sense. If someone was willing to lend you an infinite amount of money at 1.5% with a 15 year payoff, you could borrow as much as possible, invest in CDs/bonds which pay much more than that, and make free money on the delta. And sure, if you buy the CDs in taxable, the tax could impact this, but that depends on the tax rate and you could always buy these in tax deferred. The SEC yield on VTSAX is > 1.5%, meaning you get all of the growth in fund price for free, using the dividends to pay the interest on the loan.

2.75% is also low, but at least at the point where it might make sense. However, it's still less than the yield on a 10 year treasury.

So, that just leaves personal preference. In that case, no one can answer what's the best way to pay these off. That's going to all come down the personal preference, the whole reason why you're paying it off in the first place :D

I would go with Option 4. If I was forced to pay them off, I would go with Option 3. But really the rates are low enough that I might even choose based on what is more annoying to pay. I've had student loan servicers make it annoying to deal with, and have prioritized paying these off over other debts at similar rates for this reason.

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EnjoyIt
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Re: Which debt to pay down first?

Post by EnjoyIt » Sun Feb 25, 2018 6:16 pm

jucor wrote:
Sun Feb 25, 2018 5:34 pm
Several questions:

1) Is your 25x expenses in investments exclusive of your debt?
2) If you delayed going part time how many years of the higher income would it take to pay down your debt if you dedicated the difference solely to that?
3) Is your biannual exemption bundling still going to work with the doubling of the standard deduction?


Absent other considerations, I'd likely start paying down the higher interest debt first.
1) We are currently at 23x and should be at 24x or higher by the end of this year baring another recession. We do not have extra cash for debt.
2) Delaying going part time would allow us to pay the debt off in about 2 years (this includes continuing tax deferred savings as well)
3) Yes, our biannual exemption bundling will continue to be of benefit with the next tax code.
Compound wrote: Some additional information would help narrow the choices. How much money do you plan to use for debt reduction or to put into taxable accounts each month? Will you be itemizing your taxes with the changes in tax law? If so, what is the effective mortgage rate after tax deduction? How much do you dislike the debt?


I'm not sure exactly how much we plan to pay down extra towards debt. lets say $1k-$2k/month.
tax deduction question answered above. We are in a high property tax state and do some donations biannually.
We are in the 35% tax bracket
I don't like debt but understand the value of arbitraging low interest rate debt and used it to get us very close to being financially independent.

jucor
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Re: Which debt to pay down first?

Post by jucor » Sun Feb 25, 2018 6:25 pm

EnjoyIt wrote:
Sun Feb 25, 2018 6:16 pm
jucor wrote:
Sun Feb 25, 2018 5:34 pm
Several questions:

1) Is your 25x expenses in investments exclusive of your debt?
2) If you delayed going part time how many years of the higher income would it take to pay down your debt if you dedicated the difference solely to that?
3) Is your biannual exemption bundling still going to work with the doubling of the standard deduction?


Absent other considerations, I'd likely start paying down the higher interest debt first.
1) We are currently at 23x and should be at 24x or higher by the end of this year baring another recession. We do not have extra cash for debt.
2) Delaying going part time would allow us to pay the debt off in about 2 years (this includes continuing tax deferred savings as well)
3) Yes, our biannual exemption bundling will continue to be of benefit with the next tax code.

If delaying going PT would let you pay off all of your debt in two years I'd do that -- you're young, two years is not very long, and it will give you a cushion both psychologically and financially -- you'll have almost $3k/mo less in expenses for years compared to going PT sooner.

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EnjoyIt
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Re: Which debt to pay down first?

Post by EnjoyIt » Sun Feb 25, 2018 6:47 pm

jucor wrote:
Sun Feb 25, 2018 6:25 pm
EnjoyIt wrote:
Sun Feb 25, 2018 6:16 pm
jucor wrote:
Sun Feb 25, 2018 5:34 pm
Several questions:

1) Is your 25x expenses in investments exclusive of your debt?
2) If you delayed going part time how many years of the higher income would it take to pay down your debt if you dedicated the difference solely to that?
3) Is your biannual exemption bundling still going to work with the doubling of the standard deduction?


Absent other considerations, I'd likely start paying down the higher interest debt first.
1) We are currently at 23x and should be at 24x or higher by the end of this year baring another recession. We do not have extra cash for debt.
2) Delaying going part time would allow us to pay the debt off in about 2 years (this includes continuing tax deferred savings as well)
3) Yes, our biannual exemption bundling will continue to be of benefit with the next tax code.

If delaying going PT would let you pay off all of your debt in two years I'd do that -- you're young, two years is not very long, and it will give you a cushion both psychologically and financially -- you'll have almost $3k/mo less in expenses for years compared to going PT sooner.
I thought about that for a very long time and although I am "young" I simply don't want to do this for an extra 2-3 years. My role is very stressful and my time on this Earth is getting shorter and shorter. I know that if I don't invest a single extra dollar we can retire very comfortably sometime in the future just with the growth of our portfolio. Actually if we downsize a little we can retire today and debt free. With that in mind I just don't see a reason to stick it out longer than I have to. I would go part time today but I have a few obligations that keep me there for another 10-14 months.

momvesting
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Re: Which debt to pay down first?

Post by momvesting » Sun Feb 25, 2018 6:54 pm

I'm a little non-BH when it comes to debt. I like to have the smallest payment possible without paying higher interest for it. Then I will pay much more than the minimum, but I like a very low minimum so that my required monthly expenses are low. We are in a similar situation with a student loan, so I called to see what options I had. As it turns out, if I made a large payment that was not the entire balance, they would recast the loan to bring down the payment. That is what have done a few times. Now our minimum payment is under $100, but many months we send more. It is just nice to have that flexibility when another large expense comes along and I can pay it without dipping in to savings by only paying the minimum on the student loan for a month or two.

Compound
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Re: Which debt to pay down first?

Post by Compound » Sun Feb 25, 2018 7:50 pm

EnjoyIt wrote:
Sun Feb 25, 2018 6:16 pm
Compound wrote: Some additional information would help narrow the choices. How much money do you plan to use for debt reduction or to put into taxable accounts each month? Will you be itemizing your taxes with the changes in tax law? If so, what is the effective mortgage rate after tax deduction? How much do you dislike the debt?


I'm not sure exactly how much we plan to pay down extra towards debt. lets say $1k-$2k/month.
tax deduction question answered above. We are in a high property tax state and do some donations biannually.
We are in the 35% tax bracket
I don't like debt but understand the value of arbitraging low interest rate debt and used it to get us very close to being financially independent.
Thanks for the additional info. Considering the amount to contribute toward the debt is relatively small in comparison to the debt load (don’t get me wrong, it’s still great, it just won’t result in a payoff any time soon), taxable investing is where I’d focus my efforts. Taxable investing will give you flexibility and comes along with the highest probability of maximizing wealth.

Good luck.

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Re: Which debt to pay down first?

Post by tranquility » Sun Feb 25, 2018 8:35 pm

I would vote for paying off mortgage. $2400/ month will feel a lot bigger amount especially if you go part time and you have reduced income. Plus you have a higher mortgage loan rate than your student loan.

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Pajamas
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Re: Which debt to pay down first?

Post by Pajamas » Sun Feb 25, 2018 11:17 pm

Given your situation where you need investment returns it would be silly to pay off the 1.5% student debt when you could probably make more than that with a CD even considering taxes. The mortgage is a little iffier but if interest rates keep rising the 1.5% will be a no-brainer and the 2.75% will seem like a great deal, too.

You might delay making this decision for a while to keep investing. You can switch to paying down the loans at any time. Even that decision won't be irrevocable. But do remember that there is an opportunity cost to paying down a loan.

Of course, pay down the higher rate loan first, if you do decide to pay down the loans.

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Watty
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Re: Which debt to pay down first?

Post by Watty » Sun Feb 25, 2018 11:34 pm

EnjoyIt wrote:
Sun Feb 25, 2018 5:13 pm
Part time income should be enough to still max out 401k, backdoor Roth, and HSA.
Make sure that the employer will still allow you to make the 401k contributions if you are working part time. Some require a minimum number of hours for that and any other benefits.

Even with low interest rate loans investing the money and earning more is harder than it sounds because you have a sequence of returns risk. Here is an example I have posted before.
 If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.
If you have the money in a taxable account and can easily pay off the student loans I would be tempted to pay then off, but that is just me.

If you didn't have any debt then you would likely not be tempted to take out new loans just so you could invest the money.

rr2
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Re: Which debt to pay down first?

Post by rr2 » Sun Feb 25, 2018 11:59 pm

I vote Option 4.

But this depends on your preference. I would aim to get to have accumulated at least 25x Expenses (excluding debt) + Debt. In your case 25x + (325K).

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EnjoyIt
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Re: Which debt to pay down first?

Post by EnjoyIt » Mon Feb 26, 2018 12:40 am

rr2 wrote:
Sun Feb 25, 2018 11:59 pm
I vote Option 4.

But this depends on your preference. I would aim to get to have accumulated at least 25x Expenses (excluding debt) + Debt. In your case 25x + (325K).
So are you saying once I have 25x + $325k I should then start paying down the debt instead of investing more in taxable? This was my original plan BTW, but the concept of being debt free is starting to weigh on me.
Watty wrote:
Sun Feb 25, 2018 11:34 pm
Make sure that the employer will still allow you to make the 401k contributions if you are working part time. Some require a minimum number of hours for that and any other benefits.
Interesting thought, I am an independent contractor and get to choose my tax deferred space. Maxing my 401k is a must. I'm not too keen about giving it away to the government.
Watty wrote: If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.

I get the premise and the theory behind this example though there are flaws in math. It neglects the pay down of the mortgage and expects the $100k to be left intact at the end. The purpose is to use up the $100k and still have some extra cash left over. Theoretically in a long enough time frame the mortgage would be paid off and there would be a few extra dollars still left over in the account. The premise is still accurate but the example is flawed.

Also we invest in a taxable account whenever the checking account has $10k above 2 months living expenses. Just because we have an extra dollar does not mean we will take an extra trip to the dollar store. My thinking is to maybe divert some or all of the $10k towards my low interest rate debt. I think I need to calculate the actual opportunity cost. Maybe that will help me answer the question better. Maybe calculate the expected return with with growth ranging from 3%-7%. This sounds like a fun excel project.

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Pajamas
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Re: Which debt to pay down first?

Post by Pajamas » Mon Feb 26, 2018 1:28 am

Watty wrote:
Sun Feb 25, 2018 11:34 pm
If you didn't have any debt then you would likely not be tempted to take out new loans just so you could invest the money.
He probably wouldn't be able to take out fixed-interest loans at those rates at this time and certainly wouldn't be able to if rates keep rising. Might be tempting then.

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EnjoyIt
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Re: Which debt to pay down first?

Post by EnjoyIt » Mon Feb 26, 2018 2:00 am

I did the opportunity cost analysis of paying this debt down faster vs investing and added the info to the opening post. Depending on market returns of 3%-7% real I can expect a range of $13.5k - $80.5k over the life of the loans.

I think $13.5k is definitely a worthwhile price to pay for the luxury of being debt free. Although $80k is a much more substantial amount, I can't imagine 7% real returns and if that is the case the rest of my portfolio will flourish making the $80k not as impressive. Therefor I think it is worthwhile for me to pay down the debt slightly faster though I like the idea of hitting 25x first and then looking to knock down the debt shortly thereafter. The only question remains is which of the 3 OP options do I follow?

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Re: Which debt to pay down first?

Post by sport » Mon Feb 26, 2018 3:16 am

Here is some actual history: The numbers are different, but the idea is the same. There was a time when I had a 6.75% mortgage and I was earning 18% in a money market fund and 14% in CDs. I had the money to pay off the mortgage. Should I have taken money out of an account that was paying me 18% and use it to pay off a 6.75% loan? I did not, and at that time I was happy to have a loan at that rate. I ended up paying off the loan on schedule using inflated dollars.

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Re: Which debt to pay down first?

Post by gotester2000 » Mon Feb 26, 2018 4:13 am

I would say take 2 years to clear the loans and then go part time - you will be happier.

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Re: Which debt to pay down first?

Post by mega317 » Mon Feb 26, 2018 5:25 am

I don't see where you told us your absolute expenses, but if with part time work you can still max retirement accounts (and cover expenses?) then it seems like you could go part time now regardless of what you do with the debt.

I'm not impressed with those opportunity cost numbers, and even 3% has a decent chance of not happening over 13 years.

Plus it sounds like delaying the move to part time is barely an option with the stress and your mindset.

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Watty
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Re: Which debt to pay down first?

Post by Watty » Mon Feb 26, 2018 10:09 am

EnjoyIt wrote:
Mon Feb 26, 2018 12:40 am
I get the premise and the theory behind this example though there are flaws in math. It neglects the pay down of the mortgage and expects the $100k to be left intact at the end. The purpose is to use up the $100k and still have some extra cash left over. Theoretically in a long enough time frame the mortgage would be paid off and there would be a few extra dollars still left over in the account. The premise is still accurate but the example is flawed.
That example is very simplistic but over just the first year or two the paydown of the loan is pretty minor.

That example only looks at the first year of the loan.

For the real theoretical result you could make a much more complicated spreadsheet model of it then do a Monte Carlo simulation and the likely outcome would be a probability curve of likely outcomes in a form something like;

V% of the time it would turn out really badly compared to paying it off
W% of the time modestly badly
X% of the time either choice would be about the same
Y% of the time modestly good.
Z% really good.

I agree that a lot of the time not paying it off will work out well, but the chances of it turning out badly are higher than most people think because of the sequence of returns risk.

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Re: Which debt to pay down first?

Post by JupiterJones » Mon Feb 26, 2018 10:20 am

Assuming you do want to pay down your debt, then here's another vote for "student loan first, because it's smaller".

(And, as an aside, are you certain you'll still be itemizing your deductions anymore, even using the batched method, given the tax law changes?)
Stay on target...

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Pajamas
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Re: Which debt to pay down first?

Post by Pajamas » Mon Feb 26, 2018 12:42 pm

EnjoyIt wrote:
Mon Feb 26, 2018 2:00 am
The only question remains is which of the 3 OP options do I follow?
#3, paying off the loan with the higher interest rate first, would allow you to pay off all the loans faster. Might want to check any tax consequences just to be 100% sure.

Make sure that any extra payments of principle go towards reducing the balance and are not accounted for as an early regular monthly payment instead.

Paying off the smaller loan first rather than the loan with the higher interest rate first is for people who are drowning in debt and need to have the satisfaction of paying off a small loan completely and also improve their cash flow. It's a non-rational maneuver done mostly for psychological benefit. Someone in control of their finances should pay off the higher-interest rate loan first, taking into account taxes.

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Re: Which debt to pay down first?

Post by Beehave » Mon Feb 26, 2018 1:03 pm

I'm someone who does not want any debt, and you are comfortable with low-interest debt, so we come at this from different directions.

The position of carrying low-interest debt makes exceptional sense if you feel sure you can pay it off and you expect inflation. On the other hand, student debt is not dischargeable in bankruptcy. I understand full-well that you have ample resources to carry and pay-off the debt if need be, but for me, I consider student debt a risk that should be eliminated asap regardless of the interest rate and regardless of current and future wealth expectations. I'd pay it off first. I'd continue by paying off the other loans too, but that is based partly on my emotion towards debt, and reason may well dictate that it is prudent to keep them on the books as long as possible given the possibility that inflation may show up. My bottom line suggestion is to do what you think is right in conjunction with what best allows you to sleep peacefully relative to your finances.

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Re: Which debt to pay down first?

Post by CoAndy » Mon Feb 26, 2018 2:19 pm

Toons wrote:
Sun Feb 25, 2018 5:27 pm
One at a time.
Smallest first.
Start with the school loan.
Every penny you can come up with.






:idea: :idea:
What he said.

rr2
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Re: Which debt to pay down first?

Post by rr2 » Mon Feb 26, 2018 4:30 pm

EnjoyIt wrote:
Mon Feb 26, 2018 12:40 am
rr2 wrote:
Sun Feb 25, 2018 11:59 pm
I vote Option 4.

But this depends on your preference. I would aim to get to have accumulated at least 25x Expenses (excluding debt) + Debt. In your case 25x + (325K).
So are you saying once I have 25x + $325k I should then start paying down the debt instead of investing more in taxable? This was my original plan BTW, but the concept of being debt free is starting to weigh on me.
When you have accumulated 25x + (debt balances), you get a lot of options. You can pay it all off in one lump sum (subject to tax minimization). This provides the biggest bang for the buck instantly reducing monthly obligations.

This is our strategy. It will take me a few more years to get to this point. When we began to make enough to be able to start saving in taxable (after maxing tax advantaged accounts), we were considering which way to go -- pay down debt or invest. Given the longer time frames (~20 years) for the debt payoff and retirement, it seemed a no brainer to invest in taxable. With the booming markets over the last 5-6 years, this decision obviously was correct in hindsight.

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