Saving for downpayment...invest or pay off student loans?

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supersharpie
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Saving for downpayment...invest or pay off student loans?

Post by supersharpie » Tue Jan 04, 2011 11:08 pm

Prior to reading this board my wife and I planned to save $10,000 a year in taxable index funds in preparation for a move to our second home in 2021. However, many on here advised that we just keep the money in an ultra-safe investment, like our money market account which is currently yielding 1.13%. With that in mind should we just pay off my wife's student loans ASAP in lieu of investing the money? My father-in-law is paying off her primary loans (totaling about $60,000 at 3% interest) for one more year before we assume them, at which point we will have roughly $53,000 in principal left to pay over the course of seven years.

We are currently paying off an additional student loan of $13,000 at 4.5%. I was predisposed to just let things ride with regular monthly payments for the life of the loans but it seems like the guaranteed 3% and 4.5% yields might be a better bet than "gambling" on an index fund.

What say you bogleheads?

Is there a better return that we should be seeking?

imagetruth
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Post by imagetruth » Tue Jan 04, 2011 11:18 pm

You absolutely should pay off your student loans before you do any investing or saving. Why? Would you borrow $53,000 to invest in an index fund? That's effectively what you're asking.

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NightOwl
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Post by NightOwl » Wed Jan 05, 2011 3:05 am

Hi supersharpie,

You should check out the article "Paying Down Debt Vs. Investing" from the Bogleheads Wiki. Here's the link: http://www.bogleheads.org/wiki/Paying_d ... _investing

NightOwl
"Volatility provokes the constant dread that some investors know more than we do, making us fearful of ignoring such powerful price movements." | Peter Bernstein, "The 60/40 Solution."

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Post by NightOwl » Wed Jan 05, 2011 3:15 am

imagetruth wrote:You absolutely should pay off your student loans before you do any investing or saving.
Hi imagetruth,

I understand the recommendation to pay off loans before investing -- though I don't follow that recommendation myself -- but the bolded part seems overstated. Do you really mean that people should pay down low interest rate loans before having an emergency fund?

I could be wrong here, but I'm getting a strong whiff of Dave Ramsey, especially from the rhetorical question about borrowing $53,000 to invest in an index fund -- that's one of his favorite lines. Are you quoting his advice?

NightOwl
"Volatility provokes the constant dread that some investors know more than we do, making us fearful of ignoring such powerful price movements." | Peter Bernstein, "The 60/40 Solution."

Bob's not my name
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Post by Bob's not my name » Wed Jan 05, 2011 3:38 am

Are the 3% and 4.5% rates fixed or variable? Is the interest deductible for you? Are you both getting the full employer match in your 401ks? Are you both maxing out any ESPP?

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market timer
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Post by market timer » Wed Jan 05, 2011 6:30 am

What about paying down the mortgage (if you have one) on your first house? Student loan debt is often the lowest cost form of borrowing, particularly when one considers deferment options in the event of job loss, forgiveness options if income is low, tax deductibility, etc.

supersharpie
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Post by supersharpie » Wed Jan 05, 2011 7:05 am

Bob's not my name wrote:Are the 3% and 4.5% rates fixed or variable? Is the interest deductible for you? Are you both getting the full employer match in your 401ks? Are you both maxing out any ESPP?
The 4.5% is fixed, the 3% is variable. We are both already contributing beyond our employer match in our 401ks and also are contributing to the max in our Roth IRAs. After all is said and done we have about of $20,000 a year to save/invest for short and long-term goals in taxable accounts, $10,000 for each category.

Bob's not my name
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Post by Bob's not my name » Wed Jan 05, 2011 9:30 am

I'd pay off the debt unless you have a forgiveness likelihood. You didn't answer whether it's deductible, but even if it is you can't beat 4.5% or even 3% on a guaranteed short term investment. You'll want liquidity too, so I'm assuming you have an adequate emergency fund and that you can use your Roth contributions as a back-up emergency fund.

By the way, I don't agree that savings for a home purchase a decade away should be in a money market account. As livesoft has argued in other threads, a second home purchase a decade away is a very elastic goal.

imagetruth
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Post by imagetruth » Wed Jan 05, 2011 3:57 pm

NightOwl wrote:
imagetruth wrote:You absolutely should pay off your student loans before you do any investing or saving.
Hi imagetruth,

I understand the recommendation to pay off loans before investing -- though I don't follow that recommendation myself -- but the bolded part seems overstated. Do you really mean that people should pay down low interest rate loans before having an emergency fund?

I could be wrong here, but I'm getting a strong whiff of Dave Ramsey, especially from the rhetorical question about borrowing $53,000 to invest in an index fund -- that's one of his favorite lines. Are you quoting his advice?

NightOwl
I do agree with most of Dave's perspectives, but not all of them. To me it doesn't matter who said it so long as the idea makes sense.

I will say that a basic starting emergency fund ($1,000 to $2,000) should be in place so I guess yes, there should be a minimal emergency cushion otherwise you're just going right back into debt.

ResNullius
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Post by ResNullius » Wed Jan 05, 2011 4:46 pm

I'm 60 in a few days. I've always hated debt. Personally, I would pay off all debt as quickly as possible, then stay out of debt. Yes, you might need to borrow to buy a house, but I would think long and hard before buying a house in this market or at any point in the near future. Renting might just become the "new normal." Good luck.

supersharpie
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Post by supersharpie » Wed Jan 05, 2011 6:53 pm

Thanks all, it seems like paying off the debt should probably be our focus for the first 4 or 5 years, then invest the last five years.

I suppose we could always take out a bridge or home equity loan to afford the down payment if those 5 or 6 years of investing don't yield the $150,000 I project we will need between a downpayment and closing costs.

Bob's not my name
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Post by Bob's not my name » Wed Jan 05, 2011 6:55 pm

Or 401k loan.

supersharpie
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Post by supersharpie » Wed Jan 05, 2011 7:12 pm

Bob's not my name wrote:Or 401k loan.
We already purchased our first home so that is out. Hopefully home prices don't increase that much over the next 10 years. I am eying homes that presently cost $450,000 and will meet the needs of what I believe will be a growing family in 10 years. Assuming 3% annual inflation in prices those same homes will probably cost $600,000 by the time we are looking to buy.

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Post by Bob's not my name » Wed Jan 05, 2011 7:19 pm

supersharpie wrote:We already purchased our first home so that is out.
Most 401k plans allow you to take a loan for any purpose. Are you thinking of a tIRA withdrawal?

supersharpie
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Post by supersharpie » Wed Jan 05, 2011 7:20 pm

Bob's not my name wrote:
supersharpie wrote:We already purchased our first home so that is out.
Most 401k plans allow you to take a loan for any purpose. Are you thinking of a tIRA withdrawal?
Yes, that is likely what I was thinking about.

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Post by market timer » Wed Jan 05, 2011 7:45 pm

What OP needs is liquidity in 10 years.

Student loan repayment reduces liquidity in 10 years, relative to investment.

Investment, at least in bonds, likely has negative carry relative to student loan repayment (i.e., borrowing at x to earn y, where y is less than x). OP would like to avoid this cost.

Again, I ask, why not make early mortgage principal payments on your first home? This increases liquidity in 10 years, when you either sell the house to move up or extract equity through a refi to buy a 2nd home. Moreover, you do not have negative carry relative to student loans, as the rates are likely comparable. It seems to combine the best aspects of loan repayment and investment.

supersharpie
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Post by supersharpie » Wed Jan 05, 2011 7:52 pm

market timer wrote:What OP needs is liquidity in 10 years.

Student loan repayment reduces liquidity in 10 years, relative to investment.

Investment, at least in bonds, likely has negative carry relative to student loan repayment (i.e., borrowing at x to earn y, where y is less than x). OP would like to avoid this cost.

Again, I ask, why not make early mortgage principal payments on your first home? This increases liquidity in 10 years, when you either sell the house to move up or extract equity through a refi to buy a 2nd home. Moreover, you do not have negative carry relative to student loans, as the rates are likely comparable. It seems to combine the best aspects of loan repayment and investment.
My concern is that my home will lose value in comparison to the interest I could be saving by paying off the student loans quickly. In this economy you never know. At least the value of the loan payoff would be guaranteed. Aren't primary residences supposed to be considered liabilities instead of investments?

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Post by market timer » Wed Jan 05, 2011 8:00 pm

supersharpie wrote:My concern is that my home will lose value in comparison to the interest I could be saving by paying off the student loans quickly. In this economy you never know. At least the value of the loan payoff would be guaranteed.
You would be saving interest by paying down your mortgage, exactly as you would by paying down student loans. This benefit is independent of the value of your home.

supersharpie
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Post by supersharpie » Wed Jan 05, 2011 8:17 pm

market timer wrote:
supersharpie wrote:My concern is that my home will lose value in comparison to the interest I could be saving by paying off the student loans quickly. In this economy you never know. At least the value of the loan payoff would be guaranteed.
You would be saving interest by paying down your mortgage, exactly as you would by paying down student loans. This benefit is independent of the value of your home.
Yes, I realized this a few minutes after I posted the message. Considering that my mortgage has the highest interest rate of them all (4.75%) this is probably the way to go.

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Post by Bob's not my name » Thu Jan 06, 2011 4:06 am

supersharpie wrote:my mortgage has the highest interest rate of them all (4.75%)
After taxes? Mortgage interest on your primary residence is deductible against federal taxes (and state taxes in some states). For most people this makes their mortgage interest low compared to other borrowing options. You should look at how much above the standard deduction you are, and you should look at whether your student loan interest is deductible now and in future years (there's an income limit and a dollar limit), and you should definitely consider that the student loan interest rate of 3% is variable and could increase, whereas your mortgage interest rate is fixed (I assume). How high could that 3% go?

Your effective after tax mortgage rate might be under 3.5% and fixed, vs. your $13,000 student loan at 4.5% fixed and your $53,000 student loan at 3% variable.

Besides that, what's the term on the student loans? Does it go beyond the ten year window anyway? If these will be paid off before you buy that next house anyway, then not paying them down now makes no difference in your liquidity at house-buying time.

Furthermore, if you think it's a great idea to have a bunch of non-mortgage debt when you buy your next house, look into the terms and rates for loans from your 401k plans. My 401k currently allows me to borrow at 3.25% fixed with no continued employment condition.

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Post by supersharpie » Thu Jan 06, 2011 11:47 am

Bob's not my name wrote:
supersharpie wrote:my mortgage has the highest interest rate of them all (4.75%)
After taxes? Mortgage interest on your primary residence is deductible against federal taxes (and state taxes in some states). For most people this makes their mortgage interest low compared to other borrowing options. You should look at how much above the standard deduction you are, and you should look at whether your student loan interest is deductible now and in future years (there's an income limit and a dollar limit), and you should definitely consider that the student loan interest rate of 3% is variable and could increase, whereas your mortgage interest rate is fixed (I assume). How high could that 3% go?

Your effective after tax mortgage rate might be under 3.5% and fixed, vs. your $13,000 student loan at 4.5% fixed and your $53,000 student loan at 3% variable.

Besides that, what's the term on the student loans? Does it go beyond the ten year window anyway? If these will be paid off before you buy that next house anyway, then not paying them down now makes no difference in your liquidity at house-buying time.

Furthermore, if you think it's a great idea to have a bunch of non-mortgage debt when you buy your next house, look into the terms and rates for loans from your 401k plans. My 401k currently allows me to borrow at 3.25% fixed with no continued employment condition.
I guess the effective tax rate on the mortgage is 3.56%. Further, I believe that our AGI will exceed 115k in 2012 so we will no longer be eligible for the itemized deduction for student loan interest.

In that case I suppose the best game plan would be to:

1. pay off the fixed 4.5% student loan

2. pay off either the variable rate student loan or the mortgage...currently the variable rate is .56% lower than the effective mortgage rate but I know that prior to the economic crisis that the variable rate was over 6%

I suppose #2 depends upon my projection of what the average variable rate will be over remaining 8 years of the loan? The loan will be paid off as of 12/2018 if we don't accelerate payments.

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Post by Bob's not my name » Thu Jan 06, 2011 12:56 pm

supersharpie wrote:I suppose #2 depends upon my projection of what the average variable rate will be over remaining 8 years of the loan?
I wouldn't put it that way. You can't really project how bad that rate could get, so it's a matter of risk assessment.

Moreover, the 3.56% mortgage is a 30-year instrument, whereas the 3% variable student loan is an 8-year instrument. How are you accommodating the different terms in your math? Also, as noted above, not paying off the student loan does not affect your liquidity a decade from now, because it will be paid off in any case. Paying down your mortgage will affect your liquidity -- even if you sell the old house, liquidity during the transition may be important to you.

Summing up, you're allowing a possibly temporary half point difference between an 8-year loan and a 30-year loan lead you to consider assuming interest rate risk on the 8-year loan. Doesn't make sense to me.

imagetruth
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Post by imagetruth » Thu Jan 06, 2011 6:15 pm

supersharpie wrote:Thanks all, it seems like paying off the debt should probably be our focus for the first 4 or 5 years, then invest the last five years.
You can do it a lot faster than that I'll bet. If you and your wife really committed to a budget every month, sacrificed some lifestyle stuff and prioritized wiping out all your debts you could knock out the student loan and get into that nicer house in 5 years or less.

Bob's not my name
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Post by Bob's not my name » Thu Jan 06, 2011 7:12 pm

imagetruth wrote:sacrificed some lifestyle stuff ... get into that nicer house
A nicer house is lifestyle stuff. Living within your means includes living in a house within your means. Don't be in a rush to incur the substantial costs of changing houses.

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