Should I Invest, or Pay My Car/School Loans?

Alissa recently stopped by my blog and, after reading Step Two (take the free money), asked,

"I suppose this implies that I should contribute only the 3% my company matches into my 401(k) until I pay off my car/school loans. I think I've been envisioning diagrams where the longer you invest something is more important than the amount you start with so I've been putting 10% in my 401(k) just to jumpstart it I guess and feel like I'm accomplishing something at least while I incur interest in my car... hmm."


Should Alissa pay off the car/school loans? Or should she keep stuffing 10% into the 401k (which is a great thing to do)? The answer is: It Depends.

There are a few things we need to know first:

1. The interest rate on the loans.
2. The returns on the 401k
3. Alissa's tax rate
4. The risk factor on the investment

Thankfully, there is an online calculator for this: you can find it here. It doesn't include risk factor, though, so remember to think that one through on your own.

How it works

We know that when it comes to investing, time is important. Your investments compound with time, so that your money makes money, then the money your money's money makes makes money, and so on forever until it's just one huge snowball of money!

But debt works the opposite way. You owe interest on the debt, then you owe interest on the interest, then you owe interest on your interest's interest's interest... and... ouch. It rolls into a giant snowball of pain. Take a $1500 vacation, put it on your 22% APR credit card, and make minimum payments of $35... and you'll end up paying $1468 in interest alone- enough to have paid for another vacation... for the credit card company.

When it comes to 22% debts, there's only one thing to do: pay them down aggressively, because they will attack you back with the force of a hurricane and ruin your financial future. With debts like that, all you're doing is tithing to the Big Banks. 

But what about, say 3% debts?

Let's say someone is offering you a 5% investment. You don't have any money, but you can borrow it at 3%. (which is the same thing as putting off paying an existing 3% loan). Should you do it?

5% bond
-3% debt
-----
2% ahead!

Yeah! You should do it- assuming the investment is risk free (as few things are in life). Remember to take the risk of the investment into account. You do not come out ahead if you lose your investment, and you'll still have the debt to pay either way.

Stock market returns are not promised. Bond returns are a little more reliable, but they aren't promised either. Debt, however, is still going to be there for you.

Leverage

What I just described - borrowing money to buy an investment - is called leverage. If the investment works out, you will have come out ahead 2%. If the investment doesn't work out, you'll have lost everything you put in to it, and you'll still owe the original debt, which is still incurring interest. Essentially, you can take a chance on coming away with more- with a chance of losing more.

Leverage is part of what brought the big banks down in 2008. They invested with borrowed money and when those investments didn't come through, they couldn't pay the people they owed money to.

In 2008, people saw their investments drop in value, but their debts remained the same and still needed to be paid. Lots of pain and suffering ensued. This is a big part of why I chose to pay off all my debts instead before starting to seriously invest, even though I would have gotten a small tax advantage by waiting to pay off my student loans.

Taxes

Don't forget the impact that paying down debt or saving can have on your taxes!

The higher your tax rate is, the more help tax-advantaged debts/investments will give, because that's income tax you don't have to pay.

Student Loan interest is a tax deduction anyone can take (as opposed to charitable gifts or medical expenses, which you have to itemize to take.) 401k contributions are shielded from income taxes when you contribute, too (unless they're Roth).

Plug your marginal tax rate into the calculator to see the tax effect on your decision.

Fees

Don't forget fees- the scourge of investing! If your employer has crappy, high-fee 401k fund options (I've seen as high as 1.5% expense fees in people's 401ks), remember to subtract that from the return you expect to get when you're typing it into the calculator.


Conclusion

Since everyone has different interest rates, risk tolerance, expected returns on their investments, and tax situations, I can't really tell you in a blanket statement what's right for you. And unfortunately, if you have lots of different loans and can't predict your 401k's rate of return, with all the different factors involved, it can be complicated.

Me personally? I say, do the math if you can, but when in doubt, debts over 4% should get paid off aggressively, as in, strict Spartan budgeting until they're nuked to a crisp 0 balance. Tax advantaged debts under 3% aren't the worst, but if you're like me, you'll wipe 'em all out, regardless, so come what may, you'll sleep better at night.

Disclaimer: These are just my opinions, and not intended as advice for anyone's specific situation. Naturally I'm not an adviser, nor am I YOUR adviser, so you're going to want to do a little more googling and employ some critical thinking before acting on anything I say. Always get a second opinion!


3 comments:

  1. Yay helpfulness. Seeing as my car loan is 9% and idk exactly how much I'll earn from the retirement fund I'm definitely going to prioritize the loans at this point though I'm also happy to see my 401(k) have a little something in it for now. It also helps realizing that as soon as I get done paying off these debts I can put even more into my 401(k) Thanks 🐱

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    Replies
    1. Good to see you again Alissa :) Yeah, it's impossible to know what kind of returns you'll get from your retirement fund... In the long run, (like over the past 100 years) the stock market has averaged about 7% yearly, but then about 3% yearly gets lost to inflation, and 401k fees are not known for their gentleness either, which may lop off another 1%. (This might be a good time to check the fees on the fund you chose- you get some leeway, but sometimes all the options suck, depending on which company your employer went with.) In the short term, you have great years like this one which have seen double-digit run-ups, but then again, you have crap years where investments actually lose money- possibly tons, like in 2008. Anyways, high five on the savings and paydowns!

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