I've given recommendations before about how you should prioritize investing versus paying down debt. Behaviorally speaking, you're often better off paying down debt rather than investing. Mathematically speaking, there are times when investing makes more sense than paying down low interest rate debt, even though paying off the debt provides a guaranteed return. Deciding between maximizing out retirement accounts and paying off moderate interest debt, however, can be a conundrum.
Good Reasons To Invest in a 401k
- Possible higher rate of return
- Possible better asset protection (state and type of debt specific)
- Tax advantages (deductible interest, retirement account benefits)
- Maximizes Tax-Protected Space
Good Reasons To Pay Down Debt
- Known, guaranteed rate of return
- Possible better asset protection (state and type of debt specific)
- Improved cash flow
- Feeling of being debt free
Tax-Deferred Contribution Vs Moderate Interest Rate Debt
General concepts are fine, but sometimes you actually want to quantify the benefits of each choice. There are a lot of variables, including unknown future returns, but if you are willing to make some reasonable assumptions about those, then quantification of the benefits can easily be done. Consider an investor who is deciding whether to contribute to his 401K or pay off an 8% student loan. Let's say he has $10,000 and can take either option and has a marginal tax rate of 33%. First, let's quantify the benefit of making a 401K contribution. There are two ways you save on taxes by doing this. The first is that your money grows in a tax-protected manner. Since his marginal tax rate is 33%, the reality of his 401K contribution is that 2/3 of the money in the account belongs to him and he is investing 1/3 of it for the government. After 30 years at 8% per year, his $6667 dollars is worth $67,088. If that money had been in a taxable account, it would have been worth at most $53,459. So the tax-protected growth is worth $13,629.
The second way a 401K helps you save money is the arbitrage between your marginal tax rate and your effective tax rate. This investor saved money at 33% upon contributing. If his effective withdrawal tax rate is only 20%, the arbitrage is worth another $13,413, for a total of $27,042 more than he would have had in the taxable account.
The Comparison – 401k vs student loans
In order to compare which is the better decision, let's consider two scenarios. In the first, he puts the $10K into the 401K this year, and pays off the debt next year . In the second, he pays off the debt this year and puts $10K, plus the $800 in interest he saved by paying off the debt, into the 401K next year. In the first scenario, the investor reaps a benefit of $27,042 by putting the money into the 401K, and pays $800 in interest. In the second scenario, the investor saves $800 in interest, and adds that to his $10,000 401K contribution in year 2. 29 years later, he reaps a total benefit of $26,550. Thus, even with a similar 8% rate, making the 401K contribution is the right move, but not by much. What if the interest rate on the debt was 12%? Then paying down the debt comes out ahead, $27,534 to $27,042. If the debt was at 5%, then the advantage for the 401K contributor grows to $1,229, $27042 to $25,813. Keep in mind this is the advantage from just one year of carrying the debt and making a 401K contribution. If you continued to make this decision each year, the benefit (or loss) would continue to compound.
Paying down debt is never a bad thing, but when the interest rate on the debt is similar to the expected return on the investment inside the 401K, you are likely to come out ahead maxing out the retirement account instead of paying down the debt. Investing, of course, does involve taking on more risk, which should be taken into consideration. A guaranteed return of 5-8% is nothing to sniff at. If your debt is at 8% but you only manage 6% on the investment, the benefit of the 401K contribution is essentially eliminated ($15,053 vs $15,033).
Doesn't Matter Much
One observation I had after running all these numbers was how little it mattered. While there is obviously a great benefit to paying off a 20% credit card, and borrowing at 1% while investing at 8% is essentially a no-brainer, it just doesn't matter all that much when you're talking about moderate interest rates. On a sum of $10,000, it is really only a $500-1000 (per year) decision, and one year returns in the market are a crap-shoot at best. The best option is probably to live like a resident until your student loans are gone so you can both max out your 401K AND pay off your student loans.
What do you think? Have you had to decide between maxing out retirement accounts and paying off moderate interest debt? How did you decide? Comment below!
Background facts:
– Optometrist, graduated in 2013
– Student Loans: 200K, interest rates: 6.5-7.8%
– After-tax income: 100K
– Married, age 29
– Huge Dave Ramsey fans
– Working the debt snowball with a 2-3 year plan to become 100% debt free
– Not started any investing/retirement yet
Question:
– Am I better to start investing or to pay off debt?
If I were on a 10 year debt snowball plan, there’s no doubt in my mind that investing now would be better, but I’m talking about a 2-3 year delay on my investment.
Open-minded and happy to hear any suggestions.
I don’t know that investing now is quite the best idea. 6.5-7.8% is a pretty high interest rate. Due to your lower income, you may be able to deduct some of your student loan interest, plus a retirement account contribution isn’t as valuable to you as your marginal tax rate isn’t as high as the average physician.
If I were in your shoes, and really wanted my loans gone in 2-3 years, I’d try to refinance into a variable rate loan, available now at about 3%. That lowers your interest from $14K a year to perhaps $6K a year. That extra $8K can then go to principal, helping you get out of debt a few months faster. At 3%, it can make more sense to at least be doing your 401K/Roth IRA contributions. At 7-8%….that’s probably your best investment, especially guaranteed.
You really can’t prioritize one over the other. There is no incentive to keeping school debt around and a 401K match is free money. So at a minimum I would contribute to the 401K up to the maximum match, then throw as much at the student loan debt as possible, all the while living very modestly.
I was “lucky” in that my first employer out of school didn’t allow new hires to contribute to a 401K until 1 year in, so that gave me plenty of time to pay down my $14.5K loan. We knocked out my husband’s debt ($90K) in about 4 years, but we could afford to maximize our 401K’s during that period.
that’s assuming your employer will match your 401 contributions. most every group i’ve looked at in anesthesiology has self-funded retirement plans. there is no employer match
True, however at a minimum I think it’s worthwhile to consider a Roth during residency years. My husband wished he had, only got on the bandwagon his last year.
Two physician household practicing about 4 years now.
Me: 198,000 in student loans at 1.625%
Wife: 275,000 in student loans at 2.25%
Townhouse Mortgage: 248,000 at 3.65% 1900 per month
Take home 16,500 per month together
We are maxing out 401k/403b but arent do the backdoor roth at this time.
We pay about 2600 a month in student loans and have decided to throw an additional 2500 at it per month with the hopes of having it all paid off in 7-8 years.
We are getting crushed in taxes ( about 38% to federal, state, city, ss, medicare etc.)and between taxes and our student loan payment make up a significant chunk of our income. Getting rid of debt and freeing up income is our goal now eventhough the interest rates are extremely low.
We are in a similar situation to you with student loan interest rate at 1.625%, similar home mortgage and interest and maxing out the 401k/403b etc. I asked our financial advisor about paying the student loans off earlier and he didn’t think it was a good idea. “Pay the minimum and use the extra money to put into other investment or savings vehicles.” — Kids college funds, whole life, saving for a down payment on a house” –. He thought there were much more efficient ways to use the income. With this caveat — if this debt was causing us stress then pay it off earlier — (frankly as I hate debt I was considering this until I ran the numbers…..then I decided to invest elsewhere). Hope this helps!
Even at a marginal rate of 38%, you are better off paying the mortgage down than either of your student loans. I know it’s hard having such enormous student loan debt hanging over your head, but I would have a hard time paying down debt at that low of an interest rate, especially without maximizing every red cent of tax advantaged space (backdoor roth, 529s – which you can start even if you don’t have children yet).
My wife’s med school debt will be $10k of Federal subsidized loans at 6.8% and then $70k in unsubsidized family loans at 3.5%. The $70k is on a 5-year term though. We plan to max out our Roths and pay the amount needed to pay all student loans off in 5 years. She’ll start residency and our household income (pre-tax) will increase to about $100-105k. None of the residencies she is looking at offer a 401k or similar match. Would you invest more and pay of the Federal loan over the full 10-year period? Anything else you’d recommend vs. what we plan on doing?
Just $10K? I’d pay it off just as soon as it becomes unsubsidized.
Yes, she went to a state school, and she’ll graduate with a total of $80k in med school debt. She had a full ride for undergrad.
I really like your recent articles :D. I am not sure I agree with the math, but I agree with your point about it not mattering much. From a personal view, smaller student loans > student loans & investments. My employer match is $.50 for every dollar up to 6%, but has 30% vesting over 2 years. Locking away money just seems terrible. Roth IRA doesn’t seem bad, but lowering your liabilities before increasing assets helps me justify less insurance from our conversation yesterday. I will also lose my student loan deductions at some point and want to get rid of the student loans before then. The investing approach also assumes that you maintain at least that amount of income until your loans paid off since you will not benefit from increased cash flow options.
The one approach (that I will use) that I think would justify not paying off student loans is if you do IBR and are pretty sure you can get it forgiven after 10 years. In that case, I prefer to go with increased home equity, paying off private student loans, or Roth IRA->HSA->401k up to Match. If you make HSA contributions (or 401k) from residents income and file seperately you can decrease your IBR payments to $0 through residency. The HSA adds quite a bit of flexibility especially knowing that kids will be happening at some point. You can also do some cool things when taking out student loans in med school, but I am going to wait until financial aid is given before I start talking about that online (don’t worry, it is legal).
In reading this it again reminds me how happy I am that I was able to consolidate my wife and my debt at a time when interest rates were at 2.25%….I think we are pretty much in the no brainer category. Thanks for running the numbers again though to reassure me!
Correct me if I’m wrong, but those comparisons only work if the amount you have to invest equals or is close to the amount of your loans (i.e. deciding whether to invest $10k or paying off $10k of debt). Most residents/young physicians might have about $200k of debt and maybe save $20-40k per year. In my opinion, paying down the debt makes the most sense (or at least pay debt down until the amount of debt is closer to the amount of savings).
Let’s assume someone with $200k in debt and $0 in savings (fresh out of residency). Their net worth is -$200k. If they invest $20k and earn even 10%, their savings will grow to $22,000. However, their $200k debt might grow to $210k (5% interest). Now their net worth is -$188k. If they just took that same $20k and put it towards the loans, their net worth would be -$180k. Best to pay down the debt until it’s closer to the amount you can save/invest, especially if the interest rate is high and might not be matched by investing. Then these comparisons can be helpful. Anyway, just my 2 cents.
While I agree you don’t want your life overleveraged, if you have $20K on hand, your decision is simply what to do with that $20K. The fact that you have $200K in debt at 5% is irrelevant to the math behind the decision, which you did incorrectly because you didn’t consider the accrued interest.
With your example, you have someone with $200K in debt at 5% and $20K. If that person puts the $20K toward the debt, he decreases his interest payment by $1000. If he invests it at 10%, he makes $2000. Net worth after paying down the debt is -$189K. Net worth investing is -$188K. So he’s better off investing it in that scenario. Of course, the investment return involves risk, and paying down the debt does not. So you’re really evaluating a risk free 5% against a risky 10% in your example. I’m not saying one choice is better than the other, but you’ve got to do the math right.
If it is almost a wash paying down debt vs tax advantaged investing I assume paying down debt easily wins vs taxable I investing. After reading the blog I’m bought into the idea of a 20-25% savings rate, but I can only get half way there with tax advantaged accounts. So now I struggle to figure out if its more important to meet my savings goal via a taxable account or pay down student loans at 4% or the mortgage at 4.875%. I’m leaning toward some taxable investing as well as accelerating debt payback but maybe that’s just my way of not really making a decision.
I think that’s a great solution to your dilemma. When you’re not sure, why not split the difference?
I thought most student loans are forgiven at disability or death? To me, paying down the mortgage or investing makes the most sense in that case.
I guess if there is a high likelihood of disability or death before the loans are paid off you should take that into consideration. I think most docs ought to pay off their student loans within 5 years of residency graduation, which isn’t exactly a time when many are disabled/die.
Why the distinction between student loan debt and mortgage debt? Isn’t money fungible?
Money is fungible, but debt isn’t. Student loan interest isn’t generally deductible and mortgage debt it. Student loan debt also doesn’t disappear in bankruptcy, and mortgage debt does. So all else being equal, mortgage debt is a “better debt” than student loan debt, except for the fact that student loan debt goes away if you die or are disabled and no one can foreclose on your brain.
I have a question about timing. This might fall under the it doesn’t matter much category but I wonder if it is it better to pay off bigger chunks of student debt during high inflation periods, when supposedly my paycheck increases and the principle on my loan is worth less?
I think it would actually be the opposite. If inflation is high, interest rates will follow and you could probably invest at a higher return than you get from paying down your loans. High inflation favors borrowers and penalizes lenders.
Low-interest, fixed nominal debt is a great inflation hedge. I took out a student loan in 1993, paid no interest on it for 17 years, and paid it off in 2010. I basically borrowed $5K and paid back $3K.
I guess if inflation is high, you’re probably better off not paying down low-interest, fixed nominal debt. Of course, inflation isn’t very high right now.
Obviously, once inflation has been high for a bit, interest rates will go up and you won’t be able to borrow money at low fixed rates.
I consolidated my Stafford loans several years ago, and recently entered repayment. At the time, I signed up for a graduated repayment schedule (30 years), but only discovered days ago that my monthly repayment amount doesn’t even exceed the interest that is accrued that month. I guess it’s better to find out now rather than years down the line. More motivation to try to knock out all of my loans sooner…
I’m in a similar situation. One year out of fellowship and trying to figure out what to do with extra money. My student loans total 200k but are at 2.875 and my mortgage is at 3.8. It seems like the obvious thing to do would be max out retirement options and then shovel the rest into 529 accounts for my kids or other investments?
Random question…if you guys had a car loan leftover from residency that totaled 12k at 2.1% would you pay it off now or put that money in investments or a 529. I know car loans are a bad idea and we paid cash for our other car but if I pay it off now I save a whopping 1100 bucks over the life of the loan.
Although all your debt is at low rates, it is still a large amount of debt you have to service every month. A $200K 10 year student loan at 2.875% has monthly payments of $1915 a month. A 2 year $12K car payment at 2.1% has monthly payments of $628 per month. That’s > $2500, after-tax, that you generate each month before you are actually working for yourself. Assuming a 33% marginal tax rate, that’s over $3700. For a well-paid emergency doc, that’s 2 days work. And you still have retirement savings, a mortgage, food etc. Debt payments like that limit your career options. Yes, your portfolio is likely to outperform that rate over the long term, but you still don’t want your life too highly leveraged. Think of it this way. If I offered you a loan at 2% for 10 years, how much would you borrow in order to invest? At a certain point, you can’t afford it, even at a low rate.
I don’t think that’s a really fair way to look at his debt payments. Of the $2500 in payments he’s making, most of it really just a transfer of funds, he has to pay that piper one way or another. It’s the interest portion of the payment that is avoidable.
I agree that principal is a little different from interest, but the fact remains that someone who doesn’t have to make debt payments can afford to make less than someone who does, while still living the same lifestyle. People make different decisions, both business and lifestyle, when they’re debt free.
Those who locked money into a 401k instead of paying off student loan debt run a higher risk if they become disabled. No one’s disability policy will be good enough to handle student loan payments that this guy is talking about and all the money that was saved up could turn into a bad investment. I advocate paying off student loans no matter the interest from a risk and psychology aspect. All I hear when people don’t pay off their student loans quickly is that they would rather borrow on the margins.
Thanks for the advice guys. Actually my loans are on a 30 year payoff(which I know is bad) so the payment is actually less than 900 bucks and doesn’t feel terrible. Guess I got some decisions to make.
My student loans were consolidated at 3.9% 8 years ago. Is there anyway I can consolidate again at a lower rate?
Current consolidation only averages your previous rates. You could only do federal loans and must have at least one loan that was never consolidated. You will not get much lower than 3.9%. Consider yourself lucky. I am having to choose what to do with 6.8% in federal loans. (People above that have lower rates took advantage of a different consolidation program than currently available.)
I’m a current resident and my wife is as well. Current combined gross income is $86k. Together we have 330k in student loans and no other debt other than our mortgage. We own both of our 10 year-old cars outright and plan to drive them into the ground. All of our loans are at 6.5%, so investing for retirement vs paying loans down has been something I have struggled with since graduating medical school.
We’ve made the decision to max out one of our Roth IRAs (mine) and then invest in our programs’ 403b accounts up to the point that they match (2% for each). We are repaying the loans on the IRB plan, but are contributing above our required payment at a minimum of $1000/mo. We make an additional loan payment with any surplus we have each month. This puts our retirement contributions at about $650/mo + the 4% match. I’d love to do more toward retirement, but ultimately I made the decision to put a little more toward loans given the relatively high interest rate of 6.5%. That’s not a bad guaranteed return in my book. In addition, I also struggle with how much cash to save versus paying down those loans (my recent answer has been “not much”). My Ally account currently is only offering 0.87% (which is great compared to most savings account these days, but doesn’t hold a candle to 6.5%).
I realize this will all change once I’m an attending, but just wanted to offer another perspective (and opportunity to take any advice on different ways to allocate the funds). Am I putting myself too much in the hole with retirement savings, or is the debt pay down worth it (PSLF is on our radar, but we don’t feel comfortable betting 10 years of interest accrual on it). In the end, as you concluded, it may not matter much all.
I might be in the minority in saying this, but investing and paying off student loans at the same time makes it feel like your not making much progress on either. I think there is a very small chance that you will qualify for PSLF, but you are running counter to your goal by paying more than the minimum student loan amount.
If I was in your situation, I would probably pay the student loans off with as much as you can during residency and then follow that up aggressively when you both become attendings. I would not put much into tax free accounts because your taxes are already low and you will lose the interest deduction on your student loans at some point. Just my two cents. I’d be interested to see what everyone else thinks.
I like Jason’s approach- he gets some Roth accounts, which is important while income is low, gets his entire match, and then puts the rest of his savings into a guaranteed 6.5% investment.
As far as PSLF, I think this is your first big decision. You either go for it or you don’t. If you’re going for it, never pay more than you have to (Minimum IBR payments all the way through residency, no extra payments).
If you’ve decided not to go for PSLF, then it gets more complicated. You’re weighing a guaranteed return and deleveraging your life against a possibly higher return and the benefits of tax and asset protected accounts.
Thanks for the responses, folks.
I should clarify that my wife is in a 3-year residency and I’m in a 6-year residency. If I do a fellowship, that means only 2-3 years at a nonprofit to qualify for PSLF. This could realistically happen. There’s no telling the future, but we think it’s much less likely that she’ll end up working for a nonprofit for 7 years. Therefore, we make minimum IBR payments to my loans (in the hopes I may qualify), and put the excess toward hers, so that at least I would be able to max out my PSLF benefit. I’ll obviously have to avoid disability and divorce for this all to work out.
@AnkyDore – I hear your point on paying down student loans first, but as many readers of this blog probably do, I also favor a passive investment style based on well-diversified investments. I see contributing money toward each goal as one more way to diversify. Is it 100% the right thing to do? I don’t know, but it doesn’t sit right with me to put all my eggs in one basket.
Jason, I agree with a diversified investment approach similar to WCI advocates. My problem is with the approach of investing before paying off high interest student loans. 6.5% risk free growth in paying off your loans. If you are worried about not leaving anything behind, then life insurance coupled with paying off student loans would be an alright approach. WCI is saying that the math is better to invest in Roth IRA over pay off student loans. I think that is doubtful. I can do a more math based approach when I get home tonight, but the above analysis does not take into account liquidity (cash flow and ability to sell assets at assumed growth rate) and loan interest deductions/education credits. You also cannot buy and hold if you have a disability and need cash out of your retirement account. I’ll run some numbers when I get home.
Lots of factors in the calculation, and the higher the interest rate of the loan the more likely you are to be better off paying off the loan. But you have to account for the value of the additional tax deferred space. I’m curious to see your calculations on the value of liquidity, cash flow, interest deductions (that most docs don’t qualify for), and education credits. Seems tough to quantify.
Interesting strategy, and seems smart. So you’re going for PSLF with yours, and paying them off ASAP with hers.
Yes, that’s pretty much the working strategy at this point.
I’m interested to see the calculation as well. At the very least it should help to lend some shred of objectivity to conceptualizing the long-term potential return that each option presents. The hard part will be weighing each variable based on an individual’s priorities (i.e. additional liquidity may be more important to some more than others). Other variables will be more concrete.
I will work on the analysis by this weekend. I underestimated how much work I have with month end close.
Jason, I am wrestling with a similar situation. My wife is an intern who approached $250k in student loans for med school + we have a mortgage at 3.6%. We are doing IBR with no extra payments. To us, it makes little sense to be on a rice ‘n beans lifestyle and ignore retirement/investment in order to throw everything we have at her student loans. What extra payments we could make wouldn’t seem to make much of a dent anyway, and having a robust emergency fund makes us feel at ease.
We take an approach of contributing to Roth IRAs and earning the match to my 401k. Once she is out of med school (loan forgiveness an option) we can keep living like residents and make sizable hacks at the debt. Probably not the most efficient method from dollars and cents perspective but one we feel comfortable with.
Tax – From a credit or deduction perspective it really does not matter. As long as you do not have extra deductions or credits because to much money is going into a tax free account.
To WCI’s point in the original article, it is irrelevant whether the 401k makes the investment tax free because the loans have to be paid with after tax dollars at some point. It actually might hurt considering that your after tax dollars as an attending will have a higher marginal rate then in residency.
Liquidity – I am out of my depth currently on the liquidity cost of index funds. I know that they fluctuate and therefore you may or may not be able to take out money at a gain in the case of an emergency. My previous point about penalties for withdrawing early might or might not be important since you can access the investment penalty free if you became disabled.
Cash Flow- My situation is to complicated for me to see this very easily. If you had all IBR qualified loans then there really is not a cash flow problem. If times are hard, you could always switch to IBR. If you have private loans like me (not my choice) then IBR does not work as a backup. 100k loans at 7% on 10 a year note is $14k a year in after tax wages.
All this being said, do what you want. I know that my student loans are coming out after taxes. I know that I will only have so much money when my wife is in residency. I do not really want the hassle of dealing with investments when my student loans are in the 7% range. I figure that I use 10% to 15% tax brackets to pay off student loans and use before tax savings accounts to reduce taxable income when our incomes are higher instead of paying off student loans later.
If you can afford to always max out your tax free accounts and pay off student loans after residency then maybe investing during residency would not be a bad idea. I am not sure that we will be able to do that and still have money left over for things we want to do.
Question about variable rate student loans. We were able to refinance my loans as well as my wife’s. We now have the following student loans: $150,000 at 2.75% variable, $19,000 at 3.9% variable and $60,000 at 3.6% fixed (older loan before rates skyrocket). My wife finished her residency in ER medicine in July. We are maxing out my wife’s solo 401k, my employers 401k plan, as well as my HSA. We are fortunate enough to be generating an income stream of between 35-40k/month. I have been all our dumping extra money after retirement deferrals towards the variable rate loans starting with the 3.9%. My plan is to finish off the 3.9% variable then start aggressively chopping away at the 2.75% variable in the same fashion. We went with the variable rates as I anticipated being able to pay them back relatively quickly. Am I being too aggressive with this? Do you think I should be investing more in taxable as well as contributing to a Backdoor Roth? Even though the rate is variable, 2.75% is so low it may take a while before the rate creeps to around the 5% rule of thumb for paying back loans. Or should I just stick to our original plan of eradicating the student loans ASAP? We also have a 5/1 ARM mortgage at 3.99% on $220,000 (a small house that we will be looking to upgrade in a year or two) and a rental house at 5% fixed on $80,000. I did a cash out refinance on this rental house last year in order to pay down a good chunk of the student loan that is now at 3.9% variable. It was 6.8% at the time. We had one consumer “splurge” after she finished residency that resulted in a car loan at 2.25% on $28,000. Otherwise that is all of our debt .
I should add the basics- yes we have an emergency fund, disability, umbrella.
Sounds like you’re doing pretty good and have a reasonable plan. I would max out the backdoor Roths before paying down any of that relatively low interest debt. But I would probably pay off most of the debt before investing in taxable, especially since you’re planning on taking on a bunch more debt soon. I’d probably wait until the student loans were completely gone before upgrading the lifestyle with the new house. When that is your only debt, I think you can probably loosen up a bit without feeling too guilty. There’s no right answer here, but you seem a bit too comfortable with debt. You already owe over a half million and you’re talking about taking out more. Even though none of the interest rates are ridiculous, there’s no reason you two need to leverage your life so much on that income.
Ok good, sounds like I’m on the right track. We are planning to pay off all the student debt and car loans in 18 months and then consider the house upgrade. I would like to put 20% down on a new house as well. I am considering selling the rental house. It has good cash flow but I don’t know that’s it’s worth the liability. I feel like the value of having that debt off our backs will be worth more than potential leverage from investing. I was just questioning myself because the advisors we met with as my wife was finishing residency all looked at me funny when I explained that my investing plan was to get rid of our student loans as fast as possible. They suggested that the rates were so low that paying it back fast would be a mistake. We did not go with any financial advisor as I found this blog at about the same time and it confirmed what I was already feeling- we don’t need one. Enjoyed your book BTW just finished it yesterday, Wasn’t sure how the loans being variable rate would affect the decision to pay them back but it seems like the plan you outline in the book as far as how investing priorities should be ordered will work well for us. I knew we shouldn’t have taken the car loan, that one kept me up at night for a few days. It will be our last non mortgage loan ever!
The “be free of debt” vs “benefiting from low-interest leverage” is something many of us struggle with. No right answer there. Variable rate loans are all about the consequences of rising rates. If you’re going to be in trouble financially if rates rise dramatically, that’s not a risk you should run and you should pay them off fast. If it’s no big deal, then I’d pay off higher fixed interest first. You can always switch strategies if rates rise.
I have about $200k in loans at a level 5.74% (just refinanced with SoFi after reading about it here!) and $200k in gross income to play with. I’m having trouble wrapping my head around some of the concepts of the debt vs investing debate:
If you were to invest $10k in pre-tax money in a 401k wouldn’t you come out way ahead than if you had put $10k of post-tax money into the loan just based in the tax savings alone and ignoring any potential differences in returns?
What am I missing here?
You’re just missing the fact that you have to pay some amount of taxes (hopefully at a lower rate in retirement) on the 401K contribution. That said, I usually recommend maxing out retirement accounts before paying down low interest debt. Whether 5.74% is low interest or not is another good question. I’d probably have paying that off as a pretty high priority.
Thanks for your reply. After running the numbers I think that investing my leftover cash in a 401k would probably provide the best return in the long run with my interest rate, but I’ve decided it’s worth it to me to pay a five figure peace of mind fee and get out of debt ASAP.
Also, I read your book this week and really enjoyed. Thanks for all your insight.
Great post. I’ll be finishing residency in June while my wife will be finishing residency the following June. Our combine pay before taxes next year will be 300-325K. Trying to figure out what the best option as far as paying back loans would be. We have 3 different loans, two being private with an interest rate of 8%. 1 is a federal loan with an interest rate of around 3%. 200k of loans are in private and about 50k are in public loans. This is an accumulation of undergrad and medical school.
At this point we are both 29 and would love to begin saving for retirement but having that much debt with a pretty high interest rate scares me. In addition we are trying to save up for a house. Do you think its worth not putting money into a 401k for the first two years while we make a dent in our loans and have enough money to pay for a downpayment on a house?
At $325k salary, you should be able to do a little of everything. Many would suggest that you contribute to your (and potentially your wife’s) 401k up to any match your employer has, while putting as much as you can toward high interest loans. I’d just say max out your 401k as well as your and your wife’s backdoor Roths. If your wife’s residency has good 401k options, she could also contribute to her 401k for the year as well. Whatever you have left over, put it toward the 8% and your home downpayment. Try to live like a resident initially or at 2x of one. 🙂 WCI’s book summarizes it nicely (btw, I don’t have any financial interest in his book, but I did buy a copy of it).
I’m in the same boat, btw.
Rather than a dent, I would suggest paying off those loans completely! If it’s impossible with your income, then put as big of a dent as you can. 8% is a fantastic guaranteed return on an investment. I would highly recommend refinancing your private loans with SoFi or DRB pronto. If you can figure out a way to pay them off in just a few years then you can run the risk of taking a variable rate loan, with rates as low as 3% right now.
First off, thanks for all the great information you are providing on this blog, its been invaluable. So just to clarify some of the math for may particular situation to see if I’m thinking about this right…. I am in independent contractor and make ~300K/yr. Most of my 300K in student loans are at 7.5% and I have a SEP IRA. From my understanding, the contributions to the SEP IRA are tax protected and loan payments for my student loans would be taxed given my income. If I were to maximize my retirement, I would essentially be getting an extra ~33% from the government on any retirement contributions (until I hit retirement and this gets taxed of course). So theoretically if I max my retirement I am saving ~50K pretax dollars vs that same 50K put towards student loans would effectively be 33.5K (50K – 33% marg tax). After that there is calculations to compare interest saved vs compounding interest in my retirement account but it seems with the extra 33% saving for retirement would be the wiser decision from a pure dollars point of view. Am I thinking of this correctly? Thanks for any input or feedback.
I think your calculations are too exact for what will happen in reality.
You do not get to deduct your student loan interest, assuming you’re an attending. So paying them down is a guaranteed 7.5% investment which is a pretty good guaranteed return.
Your return in the SEP (I don’t recommend those, BTW, since an individual 401(k) allows a backdoor Roth and can be maxed out on less income) depends on market returns. Getting 7.5% in the market is going to require you to take significant risk, if it is even possible over your investment horizon. However, your retirement accounts get a significant, if uncertain, boost. You get the advantage of tax-protected growth, which for a very tax-efficient investment, adds perhaps 50-100 basis points a year. You also get the advantage of the “arbitrage” between your marginal rate at contribution and your effective tax rate at withdrawal. If that’s 33% or more and 20% or less, that’s a massive boost to the return for the investment. If it’s 28% for both, well, that doesn’t matter at all.
In my opinion, the best way to avoid this dilemma is to live your life in such a way that you can do both, by living like a resident (or perhaps just a little better) while maxing out your retirement accounts AND getting those loans paid off within just a few years.
This all assumes, of course, that loan forgiveness is not a good option for you.
Thanks for the fast reply. I’m relatively new to this and am trying to get my head around all of this stuff. I know I’m sort of working in generalities and that return on investments aren’t guaranteed other than paying down debt. I guess what I’m trying to do is to quantify the value of the tax protection to the retirement account. For $50k of gross earned income if I put it towards student loans I would only have ~$33.5k after being taxed to pay down loans vs the same $50k put towards retirement would be tax protected giving me the full $50k to use (a difference of $16.5k that is being used and growing rather than given to the government). Wouldn’t this add to the advantages of contributing to the retirement account? As it is I’m planning on saving/paying down debt as quickly as possible just trying to figure out if I should maximize my tax protected retirement and then pay down the debt or the other way around. Thanks again. I love the site and recommend it to all my colleagues
A better way to think about it is this:
The benefit of using a retirement account is what the money would grow to without taxation (like a Roth IRA) PLUS the arbitrage effect of contributing at one tax rate and withdrawing at another. For example, if you contribute that $50K and your marginal tax rate is 30%, and then you withdraw the money at an effective tax rate of 10%, then you’re just gotten an extra 20% ($10K) that you wouldn’t already have. Plus the money in a Roth IRA grows faster than money in a taxable account over the years. So that $45K or so that is yours in the account might over the course of 30 years grow 50% faster. So instead of growing to $500K, perhaps it grows to $750K. This is all dependent on lots of assumptions, of course.
It’s pretty easy to say that paying down 7.5% debt is probably smarter than investing in a taxable account. It isn’t so easy to say you should pass up a retirement account contribution to pay that down. Now if the loan is at 20%? Sure, pay it off before saving for retirement. If it is at 3%. You should definitely do the retirement investing first. But 7.5% is a bit of a gray area. But I think most docs, if they would just live like a resident for a few years, can max out their retirement accounts AND pay down their high interest student loans rapidly, so they don’t actually have to choose between the two.
I found this site recently and I am really enjoying reading the mix of common sense advice along with the transparency.
For those of us with access to a 401k/403b would it work for us to max our contribution then get a 401k/403b loan and use those proceeds to apply to student loans?
While I am normally not an advocate for 401k loans it would seem in this situation it would allow me to get money into a tax deferred account while paying off 6.8% student loans faster. Any interest paid on the 401k loan would at least be paid back to myself. Am I missing a potential downside to this?
You have to do the math on the 401k loan. For example you would earn about 3% on a 401k loan into your 401 account, but it would eliminate a 6.8% interest. If your not earning a very high return on your investments, then this can make sense.
HOWEVER, 401k loans come with some dangerous side effects. You typically have 60 days to repay the full amount after leaving a company, or being fired. If you cannot repay the full amount you are charged 25% taxes on the remaining amount.
Like you I have been considering this as well, however in my opinion it should only be used in very comfortable job situations or in very short repayment periods of 1 year or less.
For example a very good return would be paying for a car with a 401k loan. You would not need to pay collateral insurance for having a loan on the vehicle, and not pay huge interest rates that car loans usually have. As long as your comfortable with your job and able to pay the loan off in 1-1.5 years, this should provide a large payback.
Another example would be paying off a few thousand in credit card loans, which have huge interest rates. The difference between interest rates could be as high as 15%, which is much better then a 8% typical return in stocks. As long as you can pay back the 401k loan in 6 month to 1 year, this would provide a huge net positive for you.
Other advantages from 401k loans come when the market is crashing like in 2009. Your effectively earning -% interest rates on your 401k. If you take a loan out to pay off debt, you’ll be increasing your returns on your 401k. On top of this, the money from the loan being paid back would be used to buy the investments at the new trading value, which can really drive up your growth. If you have 20,000 in 401k, sold 10,000 at $40 per share in your investment and used it to take out a loan. you then repay the loan in 1 year, but the new share value is $20, you now have 10,000 you bought around $40 and 10,300 at $20, giving overall price of ~30. If the market recovers to $40 the next year you’ve made a 25% return in 1 year.
How does the math change if the debate is between paying on loans and contributing to a Roth 403b/Roth 401k rather than traditional 401k- i.e. for residents with low incomes/tax rates relative to what we’ll have as attendings, but enough disposable income to consider either strategy (due to spousal income, etc).
You don’t get the arbitrage, so it’s slightly less beneficial for someone at peak earnings. But if you’re comparing traditional to Roth 401(k) as a resident, the Roth is almost always the right move. Whether that’s better than your loans or not depends on the rate of the loans and how the investments perform.
WCI, I’m a 1st year EM resident with about $424k of federal loans at an average rate of 6.39%. My wife is an intern in another specialty with a loan debt of $225k at 6.15%. She will be working towards PSLF, and I will not. This is our only debt.
We are contributing about 1/3 of our take home resident salary to savings + debt by maxing out our Roth’s, having established a 3 month emergency fund, and now paying as much as possible towards my (non-PSLF) loans.
My question: the amount we can contribute to my loans per year (about $15k), is not even enough to cover the interest accrued yearly (about $27k). I am applying all of my excess payments to the loan that has the highest interest rate (7.9%), but it obviously feels like I’m doing nothing, as the amount I owe will not go down in residency. We do plan to pay my loans off within 5 years of graduating residency. Should we continue to put this much towards my loans, despite the fact that the total amount owed will not go down? Or should we divert money towards a 403(b) that is non-matching?
I’ve read your book and have recommended it to all of my co-residents. Very helpful, thanks a bunch!
Well done on dedicating so much of your income as residents to building wealth. That’s not easy and represents a significant sacrifice. I can understand why the fact that the loans aren’t going down is so painful for you. However, the truth of the matter is they are only growing by $12K per year, which is much better than $27K per year. It really is making a difference.
A couple of things to look into- enrolling in REPAYE might give you a lower effective interest rate. Refinancing with DRB also might lower your interest rate, at least of the 7.9% loan. That’ll help you cover even more of the interest with your $15K.
As far as whether to invest or pay off debt, that’s an eternal question most of us struggle with. There is no right answer, but a guaranteed 7.9% return is particularly attractive. The fact that you two are putting in $11K to Roths AND paying $15K toward loans seems like a pretty good split to me. I’d probably stick with that. If you come up with extra, I’d probably throw it toward the loans.
This all, of course, assumes you are 100% sure you’re not going for PSLF.