Which is better, being debt free, or having large investments?

May 17, 2012 1:58 PM

Should I try to pay off grad school loans this year (~50k@6.55%) or should I invest ?

I was a little inspired by the story on the blue about a guy who paid down over 100k of Harvard debt in less than a year.

I've been hoping to pay them off completely within the next 2 years. Lot's of reasons to do it so quickly but the $250 I lose each month on interest alone is enough.

But then a quote from the Harvard guy's blog made me wonder if I should re-think my strategy:

Along this same vein, one might say that at the end of September, instead of paying down $30k on my loan like I did, I could have invested the money in something as simple as a Dow Jones index, which had nowhere to go but up, and ridden the 21% gravy train from September 26th to March 23rd to net $6k.

Did he say 21%? That's way more than 6.55%! So is it smarter for me to invest than to pay off debts?

I have three main questions with this though. First, if I'm somehow able to find 2k per month to put either into loans or into investments, I will be paying 6.5% interest on the full amount for the first month, but receiving 21% on only 2k. It will take some time for the investment interest to trump the loan interest. How do I do the math on this? Does it always work out to just pay off the loans first?

Secondly, I wonder how reliable that 21% figure he mentioned is. Is he right? Would the number stay accurate for the next 3 or 4 years? Is there a risk that I'll actually lose money? (And while we're on the topic, how easy is it to invest 2k a month into this index and then cash it all out when it equals my total debt payoff amount?

Lastly, if investing is somehow smart at this stage, is the Dow Jones index really the best investment? Would it be better to invest heavily in a 401k? Is some other strategy better, e.g. splitting my monthly 2k into investments and debt payoff?

posted by brenton to work & money (34 answers total)

He didn't know the Dow would rise. He didn't know how to calculate interest. Not a superstar investor, and superstar investors don't always predict those trends correctly.

If the market falls, you could lose 21% of your money. A 6.55% after-tax, risk-free return on your money is excellent and you should pursue it.
posted by michaelh at 2:01 PM on May 17, 2012 [14 favorites]

Well, here's the kicker:

Secondly, I wonder how reliable that 21% figure he mentioned is. Is he right? Would the number stay accurate for the next 3 or 4 years? Is there a risk that I'll actually lose money?

1) In his case, yes.
2) It might. Or it might go up. Or it might go negative. No way of knowing. His "which had nowhere to go but up" is an overstatement, and is probably no longer true.
3) Yes, a big one.

If you're thinking "if I'm somehow able to find 2k per month" (emphasis mine), your outlook should probably be a conservative one. Keep the guaranteed "payoff": pay down your debt.
posted by supercres at 2:03 PM on May 17, 2012

Just to clarify, the 6.55% interest is paid by me, not earned by me.
posted by brenton at 2:04 PM on May 17, 2012

Yes, but by not paying interest (i.e., paying off your debt a year sooner, for example), that's 6.55% more in your pocket.
posted by supercres at 2:05 PM on May 17, 2012 [6 favorites]

21% is not reasonable. The DJIA does NOT perform at 21% growth over time and any kind of long-term investment strategy will never meet that type of number.

While an index mutual fund is usually a safe investment, long term planning should figure around 3-5% growth.


Pay off your loans first, write a letter to your lender indicating you want to pay off the principal portion of your loan first. That letter will save you more money in the long run than some shaky "investment" strategy.
posted by sopwath at 2:08 PM on May 17, 2012 [4 favorites]

Just to clarify, the 6.55% interest is paid by me, not earned by me.

Same difference. You're investing 50k guaranteed to earn that 6.55% which pays off your loan's interest. It's not *exactly* the same... since there's a cache flow issue, but it's reasonable way to think about it.
posted by smidgen at 2:09 PM on May 17, 2012 [2 favorites]

err.. cash
posted by smidgen at 2:09 PM on May 17, 2012

1- The probability you will get a 21% return in another, randomly chosen 6-month stretch is probably below .1%. 3-5% is probably reasonable for an average year. Of course you can lose money.

2- Yes, it is easy to buy index funds and cash them out later. Try Vanguard.com.

3- You will need to pay taxes on the capital gains when you do cash them out, and the dividends each year.

4- If you qualify for the student loan interest deduction, you should take this into account.

5- Even with the deduction, at that interest rate the vast majority of people will prefer the certain return from paying down the loans to the uncertain return of an index fund. If you had loans at a 2% interest rate, perhaps using the money to purchase index funds would be more reasonable.
posted by deadweightloss at 2:09 PM on May 17, 2012 [2 favorites]

If the market falls, you could lose 21% of your money.

If the market falls, you could lose 100% of your money.

First, if I'm somehow able to find 2k per month to put either into loans or into investments, I will be paying 6.5% interest on the full amount for the first month, but receiving 21% on only 2k.

The market did not go up 21% in any month; the Harvard guy was describing the return over a multi-month period. In the past month, by my rough calculations, the DJIA is down 7%.

Talk to a fee-based (not commission-based) financial planner, and educate yourself.
posted by Admiral Haddock at 2:10 PM on May 17, 2012 [2 favorites]

> Yes, but by not paying interest (i.e., paying off your debt a year sooner, for example), that's 6.55% more in your pocket.

Huh. So I really can think of it as a 6.55% return, as michaelh said? Never would have thought of it that way before.
posted by brenton at 2:10 PM on May 17, 2012 [5 favorites]

Yeah, avoiding interest is (roughly) the same as earning it. A guaranteed 6.5% return is fantastic - go for it.
posted by Tomorrowful at 2:10 PM on May 17, 2012 [5 favorites]

A toy example: Say you have $1000 cash, a 1% APY savings account, and $1000 debt on a 10% APR credit card. You could put the cash in your savings account and end up with $1010 cash and a $1100 debt after a year (a net loss of $90 over the year), or you could pay off your debt immediately and end up with a zero net loss a year out. You need to figure out whether your expected rate of return beats your interest rate.
posted by supercres at 2:11 PM on May 17, 2012

What the Harvard MBA guy did that was pretty dumb was to not take advantage of matching contributions to his retirement. That, right there, is free money. 100 percent interest. The FIRST thing you should do, if you have the opportunity to, is make sure that you are maxing out your employers matching contribution. Then start paying of your long-term debt in advance.
posted by rockindata at 2:11 PM on May 17, 2012 [4 favorites]

He could make that statement about the 21% gain in hindsight when he knew what the return for that time period had been. But to realize that gain, he would have also had to have taken the money out of the market before it dropped, too.

So, no, the 21% figure isn't in any way meaningful for you. That was just sort of some theoretical investment math he was talking about.

I get the feeling from your question that you're really really new to investing. That's great! But you should start doing some homework first. Here is a resource that had a big influence on how I think about investing: The Little Book of Commonsense Investing By John Bogle.

I really recommend you do some homework before you start making big financial decisions.
posted by MoonOrb at 2:12 PM on May 17, 2012 [2 favorites]

So I really can think of it as a 6.55% return, as michaelh said?

Think of it as a ~7.5% return depending on your tax return. You would have to earn more than 6.55% before taxes to end up with 6.55%. You don't pay any taxes when you make a loan payment. It's true there are cashflow issues whereas a stock investment is liquid so you could withdraw it any time. But, if you lose money in the stock market you will have cashflow issues, and not the kind that make you money long-term.
posted by michaelh at 2:13 PM on May 17, 2012

Make you money = save you money which is freed up to be spent or invested in something else. Sorry for the confusion.
posted by michaelh at 2:13 PM on May 17, 2012 [1 favorite]

It's sort of even a little better than a 6.55% return, since you've already paid the taxes on the money that you're using to pay down that debt.

On the other hand, you only truly realize the value of this type of "investment" if you actually save or invest the money saved by paying down debt. So someone who invests regularly at 5% for ten years might be better off financially than someone who pays down debt at 6.55% for the same time period, but then once that debt has been paid off, goes and spends the money on Cheetos and shows at the IMAX.

The point is that the value of that 6.55% "investment" in paying down debt comes once the debt has been paid off and you don't need to ship a couple hundred bucks off to the bank each month. You are free to do other stuff with that money. Just be sure to save some of it, or you might have been better off making the minimum monthly payment and socking a little bit away in an interest bearing account.
posted by MoonOrb at 2:17 PM on May 17, 2012 [4 favorites]

I will prudently invest the money. I will also leverage the money and follow the advice in the book, Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio
posted by jchaw at 2:26 PM on May 17, 2012

Pay down your student loans as quickly as possible. Debt is no fun. You're young, and you've got the money to pay it down. THEN invest.
posted by Ruthless Bunny at 2:28 PM on May 17, 2012

If you can make whatever drastic lifestyle changes are necessary to get together $50k in two years, socking that money away in the market would be a brilliant idea. Especially if you do so with the idea that you'll be keeping it in there long term. Talk about betting a great start on retirement!
posted by slkinsey at 2:30 PM on May 17, 2012

Pay it off! Get rid of it! You don't know if the market will go up 21% or down 21%. Anyone can pick a particular six month period to show a surprising gain, and conveniently not write about the six month period when it went down or was stable.

When it's paid off you will be FREE and you will think more clearly. You will get this always nagging thing out of your mind about "should I pay this off?" Eliminating that stress is worth a lot.
posted by caclwmr4 at 2:59 PM on May 17, 2012

Pay off the debt! We were in a similar situation several years ago - actually, we had a guaranteed return of 5% and an interest rate of under 3%, so it was a net loss for sure - and paying off the loans was the best decision we ever made. Promise yourself that once the loans are paid you'll save or invest that same amount each month going forward. If you can stick with that, you'll be in a great position by the time the loan would have naturally been paid.

That 21% return is technically true but way misleading; the Dow Jones took a really brutal hit in 2008 and 2009 and then climbed its way back up. If he used just a few years earlier as a guideline he could have lost half of his money. From August 2008 to March 2009, the market dropped 42%! From August 2008 to today, the market is up only 9.5% (2.5% a year). So the idea that a market index would do better than your "return" in avoiding all of the future interest is a long way from a sure bet.
posted by Duluth?! I Hardly Know Her! at 3:00 PM on May 17, 2012

> If you can make whatever drastic lifestyle changes are necessary to get together $50k in two years, socking that money away in the market would be a brilliant idea.

Why is it more brilliant than paying off the loans?
posted by brenton at 3:05 PM on May 17, 2012

You don't mention how much you have in savings. While it would result in more money over the long term if you liquidated savings to pay down debt, there is value in having some liquidity.

If I dropped my entire savings and investments portfolio on to my debt, I'd be almost free of it...but I would also have $0 in case shit hit the fan (for example, career-ending scandal, or catastrophic employer implosion). Then I would have to go on some high-interest credit cards to eat. Money you put in savings/investments can always be yanked back out if you need cash now, but money you used to pay down debt can't be brought back quickly.

So yes, pay off the debt. But leave some behind for the short term!

And yes, there is a risk you will lose money. I put my money in investments to try to at least beat inflation, but just today I'm down 4%.
posted by Hollywood Upstairs Medical College at 3:07 PM on May 17, 2012 [1 favorite]

I wonder how reliable that 21% figure he mentioned is.

Not reliable at all. The stock market bounces about more or less randomly. On average, over a period of years or decades, there's a good chance you can earn some money. But next month, or next year, anything could happen.

Is there a risk that I'll actually lose money?

Hell yes there is. You could totally lose your shorts. (And by "your shorts", I mean "all your money")

There could be some subtleties to your situation. For example, depending on your job and credit situation, you might want to have a decent emergency fund (in a plain-jane, no-nonsense savings account!) built up before you really start attacking your student debt. Or if you employer offers matching contributions to a 401k or something, it might make sense take advantage of that. I don't know your situation, so I can't comment on that.

But I will say this: Given the choice between putting money out of pocket into the stock market or paying down the debt, you should pay down the debt. The effective return of paying off your debt will almost certainly beat the stock market, and you really don't want to gamble at this point.
posted by jcreigh at 3:21 PM on May 17, 2012

If the market falls, you could lose 100% of your money.

If you invest in an index fund and lose 100% of your money, that means that the world economy has imploded and you won't need to worry about paying off that student loan.
posted by the jam at 3:29 PM on May 17, 2012

Pay. It. Off.
posted by dixiecupdrinking at 3:48 PM on May 17, 2012

> Why is it more brilliant than paying off the loans?

I generally agree with the other posters that if you have debt at 6.5%, paying it off is better than randomly investing the money because it is a guaranteed 6.5% instead of taking your chances on stocks.

However, there is something to be said for retirement savings and getting started with that. From what you say I'm assuming you have no retirement savings at all. Retirement savings are different from just random investments into the stock market, because they are tax advantaged (you can put money into them pre-tax and defer paying taxes on them until you retire). They also benefit from the power of compound interest, which means you really get an advantage by starting them as early as you can. For a more balanced view, check out this article "should you stop funding retirement to pay off debt?" (I do not work for Get Rich Slowly! It is just my favorite personal finance blog).

If I were you, I would not take an all-or-nothing approach to savings. If you have $2K to devote to savings per month, I would:

- put about $415 per month into a Roth IRA (this is how much it would take to max out the Roth IRA account over a 12 month period),
- put as much as you get an employer match on into a 401k because the employer match is free money (if you don't get an employer match, skip this)
- devote the rest towards paying down the debt.

YMMV depending on your emotional tolerance for debt and how crazy it's making you. I know a bit where you're coming from, I'm a doctor and I started out of med school 5 years ago with $185K in student loan debt. I have slowly but steadily been making progress on it and hope to have it paid off within another 5 years. Good luck!
posted by treehorn+bunny at 5:04 PM on May 17, 2012 [1 favorite]

I say work on both! Pay down that debt but also set aside some money to invest.
posted by kellygreen at 6:04 PM on May 17, 2012

Right now your lenders own you. Every choice you make must be made with them in your head alongside your own interests.

Get rid of the loan (after hitting your maximum on employer-matched 401(k) deals, and after making sure you have six to twelve months in complete living expenses saved up.)
posted by SMPA at 6:20 PM on May 17, 2012

Unless I missed it above, no one's mentioned the student loan tax deduction (which even adds to the standard deduction if you don't itemize.) I have trouble figuring out how much that shifts the equation, but it must weigh in some favor of holding onto the debt. Does it make 6.5 look like 6? like 4? Whatever it is, I'd think that modified number would be what you'd want to compare with the expected return and risk on the competing investment, no?

Also, is there an advantage of holding on to the relatively cheap and flexible debt in case something comes up? I think no credit card is going to be as nice if you say you can't pay for a while.

I don't want to say "No, don't pay it" because I think you probably should, but I'd still like to hear people's thoughts on whether those two factors weigh in for much.
posted by spbmp at 8:36 PM on May 17, 2012

My advice is to pay down your debts starting with the highest interest ones (think credit cards). One factor that is seldom mentioned when considering the invest or pay off debt dilemna is the fact that every dollar in interest that you earn from an investment is taxable income. Every dollar of interest saved by paying down debt is an AFTER TAX dollar saved.

To put it into some numbers, lets say you have $10,000 and you invest it and earn 6.5% (same rate as your student loan). So, you've got $650 profit which is either a capital gain ($325*0.2=$65 in tax) or taxable income ( assuming 35% tax rate, $650*0.35=$227 in tax) so you've got either $422.50 or $585 left over as your profit (4.2% or 5.85% after tax return)

Now, say you took that $10,000 and paid down your debt. You would get that $650, but it is an after tax savings meaning that you get the full benefit of the 6.5%. To earn that $650 you would have to put in enough time to have earned $877.50 before tax dollars (return of 8.78%... assuming the same 35% tax rate). The higher your tax bracket, the bigger the effective before tax gain you will see by paying down your debt.
posted by Beacon Inbound at 8:58 PM on May 17, 2012 [1 favorite]

My financial advisor's rule of thumb is this: First you fund your emergency account (six months of expenses). Then you pay off all your debts with interest over 10% (credit cards, etc.). Then you look at how you want to balance paying off your lower-interest debts, funding your retirement plan, and meeting other savings goals (like saving to purchase a house). That's going to be a different equation for everyone, based on a lot of specific variables you probably aren't (and shouldn't) be comfortable giving us here.

So I would suggest meeting with a fee-only financial planner and getting their advice. It'll run you $300 to $600 depending where you live, but it could be well worth it.
posted by Sidhedevil at 9:43 PM on May 17, 2012 [1 favorite]

And as others have said, there is no "21%". That was a blip that was due to a bunch of converging cicumstances that are unlikely to repeat for quite a while.

Maybe if you put cash into a DJIA index fund next month, it would be up 2% over the year. Or down 2%. Or up 6%. Or down 6%. A financial planner can explain this to you.
posted by Sidhedevil at 9:48 PM on May 17, 2012