Paying 6.55% loan quickly vs. investing elsewhere?
January 13, 2010 1:15 AM   Subscribe

Better to pay off a 6.55% interest loan quickly (if I can afford it) or pay minimum payments and invest elsewhere?

I'm doing some financial planning for my short term future (next 3-5 years) which will include grad school loans.

Based on my calculations, I'll probably leave school with at least $21000 in 6.55% loans. I'll also have other school loans, but it will make sense to pay those off as slow as possible (at 3.25% and 4.75%). With the 6.55%, I'm not as sure.

Thus, my question: Would it be better to pay off the 6.55% interest loans quickly if I could afford to, or would it be better to pay them off with minimum payments and invest the money elsewhere?

The reason I ask is because I'm unsure of what kind of returns to expect, on average, with other forms of investment (since I haven't really invested before). Maybe you guys can tell me what kind of returns to expect from common investment options (I'd probably lean a bit toward the conservative side in terms of risk)? Since I'll be fresh out of school, I probably won't be able to afford some forms of investment that require a higher initial investment.

One positive of paying the 6.55% loans slowly is that the interest would be tax deductable if my AGI is less than $70000 (I think). However based on salary surveys for the kind of career I'm pursuing, it will be likely that I surpass that AGI within 3-4 years of graduating.

Also to note, beside the school loans, I will have no other form of debt, so I wouldn't need to prioritize paying something else off like a credit card.
posted by NeoLeo to Work & Money (23 answers total) 4 users marked this as a favorite
Investing conservatively likely means bonds or CD's. A quick online search shows that, for a timeframe of 3-5 years, either will return 2-3%.

If you're between 34k and 80k per year, you're in the 25% income tax bracket, cutting the effective interest rate from 6.55% down to 4.91%.

Numbers would indicate paying down debt. However, I'd recommend that you max out your Roth IRA contributions first. I cannot stress how much getting a headstart on that will benefit you later.
posted by dualityofmind at 1:26 AM on January 13, 2010

In this economy, it would be crazily optimistic to garner anything even approaching a 6.55% return (let alone something better) without crazy risks. If you deduct interest payments, then the effective rate of interest you're paying is less . . . but still nowhere near low enough that you should feel confident about your investements doing as well or better. The way I look at it, if you did pretty well with investments, you wouldn't be gaining *that much* anyway, once you subract the 6.55% you're paying, or its tax-reduced lesser amount.

So pay it off quickly, it'll be one less thing to ever have to think about, at any rate.
posted by Dee Xtrovert at 1:33 AM on January 13, 2010 [1 favorite]

It depends on whether you are risk-averse or not. If you're risk averse, it would be sensible to pay it off.

6.55% is a better than an interest rate that you'll get on a commercial savings account or bond, from my limited research.

If you're not risk averse, there are still some investment opportunities.

Despite a rally, the Dow Jones Industrial Average still has some ground to make up from the highs of pre-Lehmans and the financial meltdown. Yesterday's high was 10,701.48. In early March 2009 it was 6,922.59. In May 2008 it hit 13,170.97.

In summary: the stock market has recovered a lot, there are individual bargains out there to be bought, but the "foolproof" bargains as canny investors picked up some treats in the fire sale almost have largely gone. It's a judgment call as to how much, and when, share prices will go up over the next year.

Finally, In the UK (as an indication), consensus thinking forecasts some sharp interest rises from May this year. There are analysts who disagree with this view, of course.
posted by MuffinMan at 1:34 AM on January 13, 2010

I agree with dualityofmind - max out your retirement stuff, and then put the extra into paying off student loans.
posted by bigmusic at 1:36 AM on January 13, 2010

6.55% is a better than an interest rate that you'll get on a commercial savings account or bond, from my limited research

I don't see how it makes any sense to compare the interest rate of a loan to the interest rate of an investment vehicle in this way.
posted by jon1270 at 2:39 AM on January 13, 2010

I don't see how it makes any sense to compare the interest rate of a loan to the interest rate of an investment vehicle in this way.

Because to make a fair comparison, you have to ask whether you'll end up better off after having used your available capital to pay off the loan, or after investing it elsewhere. The alternate investment has to net a return greater than 6.55% *after* tax for this to be the case: otherwise, the interest on the loan is costing you more than any gains you've made on your investments!

In the UK, interest on deposits or bonds is taxed at your marginal income tax rate. So to make a net profit after tax, you'd need to find a bond paying more than 8.18%. That's not possible without taking significant capital risk in the current environment as far as I'm aware.

You could invest in shares in the hope of capital gains (and dividend income). Again, both of these are taxed, and the capital would be at risk. You'd have to have an expectation of > 8% gains a year to beat paying off the loan, and be willing to ride out dips in the stock market. The last ten years in the markets have been awful for the average investor. Maybe things are about to turn around?

Personally, I'd suggest that in the current environment where paying off a loan nets you the equivalent of a guaranteed 8% return elsewhere on your outlay is a pretty good choice. Much depends on likely future income & attitude to risk of course.
posted by pharm at 2:53 AM on January 13, 2010 [1 favorite]

I don't see how it makes any sense to compare the interest rate of a loan to the interest rate of an investment vehicle in this way.

How so? You can break it down pretty simply:

Say you have a $100 debt at 6% interest, and $100 in the bank. You can:

a) Pay off the debt. You now have $0 and owe $0.

b) Keep the debt and invest the money. Say you get an 8% return, and are in a 25% marginal tax bracket. At the end of the year you owe $106, and have made $8 on your investment, of which you pay 25% x $8 = $2 in tax, and wind up with $106. For all intents and purposes, it's exactly the same outcome.
posted by bjrubble at 3:09 AM on January 13, 2010 [1 favorite]

As a practical answer, I'd say keep the loan and invest. The market is still pretty depressed; outside of a double-dip recession I'll be surprised if the broad indexes rise less than 10% over the next year. I have a car loan at about 6%, and I'm keeping it even though I could theoretically pay it off now.
posted by bjrubble at 3:15 AM on January 13, 2010

Lots of good concerns cited in answers above. One additional consideration is liquidity. Are there any goals you have in the near to mid term that will require lots of cash? For example, maybe you will get married--weddings can be expensive. Or maybe you will want to buy a house or a car. If you sink the money into the student loans, it does reduce your liabilities but then you don't have the cash for something else. If you invest it conservatively, the money will be around if you need it. Just something to think about; of course what is best for you depends on your situation.
posted by massysett at 4:18 AM on January 13, 2010 [2 favorites]

Whilst notionally, it may look like you can do better - in practice it will be difficult for you to "beat the spread", so to speak. Pay your loan off. This particularly applies if it's an indexed loan - if interest rates go up, your investments will profit, but your debt will grow equally.

With only a few exceptions at certain points in time, at the low risk end of the market, it's pretty unusual for a commercial investment rate to beat a commercial debt rate. If it did, everyone would be doing what you're thinking about, and banks would go broke.

If you want to take on a little risk, you could maybe beat the rate, but unless you're talking some pretty high debt levels (like a mortage, for example), it's really not worth the small gains, imho. And if you assume a bigger risk, with either a bigger debt/investmet or riskier investments, the gains may be bigger but if it goes wrong you're truly fucked. Pay off your loan, do it quickly, then invest.
posted by smoke at 4:36 AM on January 13, 2010 [2 favorites]

given how low interest rates are today 6.55 on a student loan just seems extortionate. what country is this in?

Pay off the loan.
posted by mary8nne at 4:53 AM on January 13, 2010

Say you have a $100 debt at 6% interest, and $100 in the bank. You can:

a) Pay off the debt. You now have $0 and owe $0.

b) Keep the debt and invest the money. Say you get an 8% return, and are in a 25% marginal tax bracket. At the end of the year you owe $106, and have made $8 on your investment, of which you pay 25% x $8 = $2 in tax, and wind up with $106. For all intents and purposes, it's exactly the same outcome.

I don't want to derail so I'll refrain from pursuing this further in the thread, but I wanted to comment that the interest rate you've used to make the two options "exactly the same" is improbably high, and seems possible these days only in high-risk investments. If you consider the risks involved, i.e. that paying off the loan and arriving at $0 is a zero-risk maneuver, while investing the money at a high interest rate to arrive at the same $0 balance is a high-risk proposition, the two are not the same at all.
posted by jon1270 at 5:06 AM on January 13, 2010

mary8nne, I don't know about the original poster, but in the United States most federal student loans have been at 6.8% interest for at least 4 years.
posted by adamwolf at 5:07 AM on January 13, 2010

adamwolf, that's true, but many lenders, including mine, offer a 0.25% discount for using an automatic debit method of payment, which would take the 6.8% down to 6.55%.
posted by valkyryn at 5:47 AM on January 13, 2010

Spend some time creating a financial plan, and financial goals, so that questions like this, which will keep coming up, are easily answered. Having financial goals makes it much easier to achieve financial goals (sorry that sounds so stupid) and makes you more likely to have the chance to retire early, buy a house, send kids to school, etc.

Make sure you have an emergency fund, then pay off the loan. You're young, and this is a smart question. Keep it up.
posted by theora55 at 6:57 AM on January 13, 2010 [1 favorite]

Also, are these loans variable or fixed? If they are tied to the LIBOR, I can almost surely tell you that interest rates are going up and not down. This may help you make your decision. I am in the same position as you, except my wife and I have passed our AGI and will not be recouping much, if any, of her interest.

Pay off your school loans if you have an emergency fund. If not, build the emergency fund first. Put the emergency fund into a high yield money market account, we use our local credit union with a 2% interest rate which is pretty good, but I have heard ing is pretty good as well.

Pay off all credit card debt and then start thinking about the school loans. If you can recoup your interest for this year, you may want to figure out how much interest you will be paying and add that into your payments over the course of the year as well.
posted by TheBones at 8:49 AM on January 13, 2010

A good quick resource for 80/20 financial advice is Ramit Sethi's I Will Teach You To Be Rich book and blog. There are some good calculators there and listed in the book. His advice would be that it probably depends on where you find yourself after graduation. If you get a job at a company that matches 401k deposits, max out your 401k to the limit of the match (it's free money). After that your decision is between a Roth IRA (you can't back-fill an IRA, so every year you don't invest is a year that's gone) and paying down the debt. You may want to split the difference, invest a chunk in a Roth and use a chunk to put in an extra payment every year or quarter.

Student loans aren't as volatile as credit cards, so the urgency isn't as great. I'd say pay down as you can, but prioritize 401k and Roth investments.
posted by jeffkramer at 8:58 AM on January 13, 2010

6.55% interest on a school loan is extremely high. Rates on car and home loans are invariably lower, so you're better off paying off the school loan now. Any money you have to borrow to buy a house or a car will be borrowed at a lower interest rate, saving you money. So pay the 6.55% loan off as quickly as you can.

Echoing jeffkramer, though, your priority should be on your IRA and 401k accounts, because of the yearly contribution limit: once you lose the chance to hit the limit, the opportunity is gone.

So the priority of paying/saving goes:

6.55% loan
savings for house/car
other investments
low interest student loans
posted by deanc at 10:57 AM on January 13, 2010

I'm not sure why everyone thinks 6.55% is so high for student loans. Stafford loans--direct through the federal government--are 6.8%. Private loans are generally higher. These are standard rates...
posted by jckll at 12:52 PM on January 13, 2010

You can invest in Even if you only invest in A-rated loans, you'll get 7+% back over 3 years with an extremely low rate of defaulting. You can spread your investment over many loans to hedge risk. Great return there.
posted by kryptonik at 1:10 PM on January 13, 2010

Wow, lots of informative answers in such a short time. I feel like I can mark most of them as best answers. A big thanks to everyone who has commented.

I'm currently planning to be done with school in mid-2013, so if interest rates increase by then, that will change things up a bit. (However, it's possible I would be done in 2012, 2014, or 2015 depending on certain factors that will clear up in next few months.) I don't expect bonds/CDs to remain at 2-3% by that time, so I'm thinking maybe it will be more like around 3-4% (if the economy recovers by then). That, along with a few years where interest will be tax deductible, will probably make minimum payments to the 4.75% loan an attractive option.

However, from the consensus of opinions here, paying off the 6.55% seems to be a no-brainer. Seeing that, I came to the same conclusion as jeffkramer: to put money into 401k up to the company's match, then focusing on the 6.55% loan as well as a Roth IRA.

Priorities would seem to be:
#1: emergency fund of a few thousand
#2: 401k match
#3: 6.55% loan and/or Roth IRA to annual limit
#4: 4.75% loan, car payments, and/or home loan payments
#5: 3.25% loan

- pharm and bjrubble: For some dumb reason, I hadn't considered that even if I DID end up with an investment that would earn over 6.55%, that any gains would be taxed as well. Great point.
- massysett: Good point as well. Since I'm the type of person to change locations often, I probably wouldn't invest in a house any time soon. Marriage and buying a car are big considerations as well, but both are more in the "it will depend when the time comes" category for me.
- mary8nne: The 6.55% rate is for a 6.80% federal Stafford loan (in USA) after a 0.25% reduction (which comes from doing automatic electronic payments). 6.8% is the rate for graduate school loans and it seems it will stay that way for the near term future. For undergrads, they are annually reducing the rate from now, 5.6%, to 2012, 3.4%.
- TheBones: All of these loans are fixed. If I'm correct, the federal government has stopped giving variable rate education loans since 2005 or 2006. For people who lucked out with the variable rate loans and haven't consolidated them, they'd be able to consolidate them and lock up an interest rate below 2% right now.
- deanc: Wow, I hadn't known that car/home loans should probably be beneath 6.55%. That's good news for me because my credit is good :). Also, excellent point on IRA annual contribution limit. Thanks
- kryptonik: That LendingClub rate is good and I've heard good things about them. Definitely something to consider. But I'm not too knowledgeable about how they deal with people who default, I guess I'll look into that later on.
posted by NeoLeo at 4:25 PM on January 13, 2010

Debt free.. Always be as close to debt free as you can get at all time.. Murphy has a way of coming in and messing with your life, not having to make a payment on something when you lose your job, or you total your car, or any one of a thousand other things is a great way to live..

You would be surprised at how fast you can make up those few dollars you 'might' have made playing an investment against a debt when you don't have the debt holding you back..
posted by SteveG at 7:19 PM on January 13, 2010

Ran into this article about person to person lending websites. I don't know if it applies to LendingClub, but it can certainly make you think twice about it.
posted by NeoLeo at 1:44 PM on January 20, 2010

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