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Debt repayment advice for Sam
Sam of FinancialSamurai.com asked:
So here’s the question that perhaps you and the readers could pitch in and share their thoughts. I’ve currently got about $30,000 in consolidated student loan at a rate of 2.68%. I decided to do an extended repayment period (20 years), given the rate was so low, and savings on CDs and interest rates were around 4-6%, hence a positive carry. Recently, however, the best 5-yr CD rates are at only 2.5-2.75%. I’ve got to pay taxes on the savings interest income of course, and at the same time, I can’t deduct the interest payments on my student loan because of income limit restrictions (thanks big government!). To add another wrinkle to the dilemma, I’ve got a rental property mortgage at 5.25%, which I’m chipping away at so I can pay it off in full in 15 years (in 8 years), instead of 30 years. I’ve got no other consumer debt. And currently, my “Freedom Fund” listed on my site, which is cash, is up to $95,500. Psychologically, paying off the student loan will provide mental relief, a benefit that’s hard to value. I’m just worried that if I pay it all off, or a large slug, that money will be inaccessible forever. Where else can I borrow money at 2.68%? What would you and the readers do?
- Pay off the student loan in full given savings rates are at parity?
- Attack the student loan with extra principal payments every month or year? If so, by what amount a month/year?
- Let it be, and focus on paying off the higher interest rental property loan at 5.25%, even though it’s a much bigger loan, and I won’t get the same sense of accomplishment?
- Do nothing and sing kumbaya?
Thanks for your thoughts!
Pay off student loan debt, rental mortgage debt, or save?
Should Sam pay off his entire student loan debt? Should he put the Freedom Fund toward the higher rate rental mortgage? Should he sit on the savings and continue to faithfully chip away at both debts while building savings?
Here is what I would do Sam:
Although rates are low on the student loans… debt is still debt. If you reduce your debt you always win because it is guaranteed to pay returns by reducing your cost of living. Another reason debt should go is because concerning ourselves too much with rates can blind us to the fact that carrying debt means we are actually presuming upon our future ability to earn.
Assuming your entire $95,500 is all in liquid savings I would order your above options as follows:
- Pay off entire student loan debt and be done with it once and for all.
- Keep enough of the Freedom Fund aside for a solid 6 month emergency fund… say $20k – $25k according to your monthly budget.
- Use the remainder of the Freedom Fund to fully fund your 401k and/or IRA (if you have not already done so.)
- Once your retirement accounts are fully funded, use any remaining amounts to further pay down your rental mortgage early.
So as an example, if I had the $95,500 I would put $20,000 into my high yield savings account emergency fund. I would then contribute $16,500 to my 401k, $16,500 in my wife’s 403b, and another $5,000 to my Roth IRA, and $5,000 to her Roth IRA. Once all this was accomplished I would use the remaining $32,500 to further reduce the rental mortgage.
Whatever you decide to do… if you ever start stressing, just sing kumbaya. 😉
What do you think Sam should do?
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Great question Sam and a great answer Matt.
I would pay that student loan off tomorrow. What fun is a FREEDOM FUND if you really aren’t DEBT FREE?? Sorry Sam, just my thoughts.
I understand using the money to make money, but I’d much rather not worry about having a student loan over my head than making an extra 2-3%.
I would order the options like Matt did. I would leave $10,000 in the Freedom Fund to give me motivation to build that back up quickly. The 10K would come from the 32K for the rental. Changing that amount to 22K, which is a great starting point to blasting away that mortgage.
Best of luck Sam 🙂
Matt Jabs says
Thanks Jeff. Do you think he should keep an additional $10,000 in addition to the $20,000 emergency fund mentioned? I suppose I was in essence considering the emergency fund and the freedom fund one in the same.
Financial Samurai says
Thanks for your thoughts Jeff. Tis true, I’m not debt free, and the feeling of not being debt free hasn’t bothered me, yet.
But, with every tick down in the savings rate, it starts making me wonder.
@ Matt – Thanks for your suggestions. Drop a $32,500 slug to pay off the rental still lives me with a big rental mortgage. Hmmm, doesn’t feel that great.
Right now it’s 2:1 paying off loan to paying off rental. Will check back later this evening!
Mike Piper says
As to how much to keep in an Emergency Fund, and whether to invest before paying off debt, that depends upon your situation.
But I’d recommend wholeheartedly to pay off the entire mortgage before paying a dime more than you have to toward the student loan.
But that’s just me. To me, paying off low interest debt when there’s higher interest debt on your balance sheet isn’t “freeing yourself from a burden” but rather “wasting your hard-earned money.”
If you are leaning toward paying off the student loan first, at least do yourself the favor of calculating how much more money (and hours worked at your job) it’s going to cost you as opposed to paying off the mortgage first. Then you can at least make an informed decision.
Financial Samurai says
Hi Mike – I ask myself all the time, “Where else can I borrow $30,000 for 2.68%?” and the answer is, nowhere, except if I wanted to buy an expensive new automobile for 1.9% financing! lol.
This is the whole dilemma… pay off the mortgage, which is much larger than the student loan… so there is no enjoyment of big progress.
The lower CD/savings rates go, the more I feel I should pay off the student loan.
WRT to the rental, I guess my indecision is my feeling that it’s an illiquid, and I might just sell the place when I retire rather than keep it as a cash flow positive asset.
Pete @ Bible Money Matters says
If I were in this situation I would pay that student loan debt off tomorrow – and just get it out of the way. In my mind there’s something to be said for just getting rid of a burden like that right off the bat. Yes, there may be some slightly better mathematical ways to do it, but the momentum you can build by paying it off right off the bat are there.
After paying off the loan I’d probably keep about 30k in the account as an emergency fund of sorts, and then use the rest pretty much the same as matt above. I’d work on getting that mortgage paid off ASAP.
Financial Samurai says
Howdy Pete – Thanks for your thoughts.
I’m actually kind of surprised that nobody is advocating Option 2: “Attack the student loan with extra principal payments every month or year. If so, by what amount a month/year?”
Interesting it’s either all or nothing yeah?
Is the rental even a write off? I know that beyond a certain income level, the loses just accumulate you can’t take them against ordinary income.
I’d think that you can put the $30K in tax free munis and come out ahead. Consider that DVY has a yield of over 4% and all the potential gain over the next 30 years. If I could borrow money at sub 3% fixed, I’d do it in a minute.
If you would sleep better paying it off, just do it. I’d make a different choice.
Financial Samurai says
Hi Joe – Good Q. Given it is a rental, all expenses, including property tax, HOA, mortgage interest are used to counteract all rent received. The IRS treats it as a business.
The are limitations if it was just a vacaiton property. The interest mortgage deduction phases out after a certain income.
I’ll take a look at DVY, thanks for the alternative investment suggestion.
Evolution Of Wealth says
I wouldn’t pay off either. You have an awesome opportunity here. It’s not going to happen overnight but you can set some things in motion that will vastly improve your current situation. You have 20 or 30 years to beat your low interest rates and like you said where else can you get access to that kind of money at such low rates. I would definitely not risk it in the market though. You need this money, maybe not today or tomorrow but you need the money to be readily available if and when you decide to pay off these debts. In the meantime, you’ll need some safety, liquidity, tax deferral would be great, tax free would be even better, throw in a competitive rate of return and you’ll be reading to fly.
If you want to get into the nitty gritty just let me know…I’ll need a little bit of info:
1. min. payment to student loans
2. current amount you are paying or max you could pay
3. payment to mortgage
4. current amount you are paying or max you could pay
5. Why so much in the “Freedom Fund”? What is the minimum you would be comfortable there?
20 years is that what’s left on the student loans? You’re still a young guy huh? Can I ask how old?
Financial Samurai says
EOW – Thanks for your thoughts. The loan was taken consolidated in 2006 after I finished business school part-time. To give you a hint on age, the average age of my part-time business school class was 32 then, +/- 5 years.
The “Freedom Fund” is planned to grow to $1 million bucks by the year 2018 or 2019. The fund is just that, for financial freedom where I can hopefully draw $30-50,000/yr risk free from it during “retirement.” Add on another $50,000/yr in rental income from the rental property which will be paid off by them, hopefully from just these two assets alone, there will be $100,000/yr.
The payment on the loan is only about $210/month, which is automatically deducted from my checking. $210/month to pay off $30,000 for the next 16 years seems reasonable, no?
Robert Espe says
Christians have an obligation to repay debts, and to be debt free (“do not say come back tomorrow when you have it with you today”, and consider Christ’s admonition that slave’s should purchase their freedom in light of the fact that the borrower is slave to the lender, as well as the direction to owe no man any debt but that of love) , so any discussion of whether it makes sense to keep borrowed money is disingenuous, no matter how good the rate.
What order you pay off debts is your business, but I would point out that the student loan (it is consumer debt) should have been paid off before the mortgage was even purchased. So I would do it now.
I would keep a $10k emergency fund, no other cash other than monthly checkbook balance. It only needs be enough to met bare expenses until you can replace it if used, or find a new job if that is the emergency.
Then kill the mortgage before putting money in retirement accounts. Investing monies must be surplus, but you can’t really afford to lose money when you have outstanding debt. In addition, those monies become inaccessible to help pay the mortgage in the event of an emergency. Especially right now, I think you will find it difficult to beat 6% returns averaged over several years in the market (especially once you start subtracting 5.25% from all gains). Once you have no debt, you can put even more into the market, and your ability to keep the money there will ensure you see returns over time. Good luck.
Robert, I understand following one’s religion. Go for it. I struggle however, when one it uses it to answer a question from an angle that may not be sound financial advice. FS works for a company with matching 401(k) I believe. To suggest that he forgo saving his money pretax and having it immediately doubled in the account in order to pay off sub 3% money is not sound financial advice. Living life linearly, paying off student loan, then getting and paying off the mortgage, then saving is not how most people live.
Why is he trying to beat 6%? The SL rate is 2.68%. The 5.25% he has on the rental is closer to 3.78% after taxes.
Here’s my concern with your approach. Someone with no debt except for the house loses his job. With no job, there’s no easy way to borrow cheap money. The bank would foreclose faster on someone with high equity in their home. Same person saves in retirement account, 5% matched each year. 10 years in, he has more than a year’s gross salary saved, only have from his own deposits. Even after 10% penalty and taxes, he’s secure for a couple years, not the months the $10K offers.
Debt might be debt, but cashflow is also cashflow as you point out. I can’t say I’m willing to trade a large chunk of upfront cash to eliminate low-interest debt.
Tax free munis are probably worth a look for you right now.
Matt Jabs says
Exactly… it’s all about what you want Sam deems as important for his situation at this point in time.
Robert Espe says
I agree with obtaining matching dollars from an employer, usually this is a small 3%-5% of ones salary. This money is doubled with zero risk. That is different from contributing the max allowable, for which risk is required to obtain a substantial return (which makes sense only if you have no other obligations). The return on paying down his rental mortgage is 5.25% (zero risk), higher than the current return on savings, or likely short term return from the market (after taxes, and money lost to debt interest).
My point was that a bulk of comments, and initial concern was whether more money could be borrowed at the same rate as the student loan (for emergencies? who needs $95K in EMERGENCY savings?), when the ability to easily repay it exists. My point was that for a Christian (this is a Christian PF blog) the goal should not be to borrow more money. From a strictly pragmatic view, one seeking freedom from debt cannot obtain it by borrowing more.
My position about repaying the student loan first was not based on religion but was purported to restore proper ordering to his obligations. The mortgage should never have existed before the student loan was paid off, so to eliminate is simply to bring Sam to the point of being free from consumer debt (which is where you want to be to have a mortgage).
All this buzz about cash flow misses the simple truth that no matter how much you make and how hard you work, there is a finite (and usually projectable) amount of money that can be earned in an individual’s life (and therefore, a finite quantity of things can be bought). Money spent on interest now, no matter how good your cash flow means you will have spent that money on something (unnecessarily to boot), and you cannot spend it on something else, nor can you replace it in the really big picture. The fact that adults consistently fail to realize this shows they haven’t moved beyond the child who can’t wait to eat a marshmallow for the promise of two.
Personally i would rather pay off the mortgage first based on the higher interest rate. Mortgages are usually compounding interest rates vs. the simple interest rate of a student loan. Also, I know in my situation I pay PMI on the mortgage until i get it to 80% of the loan value. I’d probably keep about 25k in the bank, then pay off debt with the rest of it (assuming you have a retirement plan already set up). I dont know what the fixation on paying off student loans are. My wife has one and we agree to diagree about it all of the time. She basically wants it paid off because its smaller and its “her” debt, since all of our other consumer debt is paid off. I’d rather pay off the higher interest rate on anything first; but thats just me.