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Taxable account vs paying off debt early

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  • Taxable account vs paying off debt early

    I fully understand the argument that paying off high interest debt should take priority over a taxable account in most circumstances. But what about the type of 4-5%, non-mortgage debt that I'm sure a lot of us younger docs are carrying right now.

    I personally am carrying a practice buy-in loan at prime + 1% variable (currently at about 4.5%) with about $300K in principal remaining over a four year term. Right now, I've got the cash to pay off the principal completely and be done, but that would drain a substantial amount of my cash savings.

    Rather than pay off the loan, why wouldn't I put the cash amount of $300K into a Vanguard Admiral Intermediate or High Yield municipal bond fund (both average 10 year returns north of 4%), and let it compound, adding to it with extra savings each year? Maybe my math is wrong, but doesn't the compounding effect of growth make this a better decision than using the funds to pay off the loan early? Especially since the amount of monthly payments going to interest vs principal will only decrease as the loan gets closer to being paid off.

    Here's my math:

    Year 1 $300k @ 4% growth = $312,000. Year 2 @ 4% = $324,480. Year 3 @ 4% = $337,459. Year 4 @ 4% = $350,957. Add in some extra savings each quarter and you've got even more compounding going on. Not to mention the benefits of maybe adding in some stock index funds for the potential of even more growth (although of course that would also bring in higher volatility), and the fact that you would have the option to liquidate the funds if needed for some other purpose. And on a practice buy in loan like this, interest paid is deductible against any taxable investment gains you have for the year.

    When the loan numbers are run on a calculator at a rate 4.5%, the total interest paid over the four year period to the bank would = $28,370. So maybe my math skills are rusty, but doesn't a gain of $51k beat a "loss" of $28k, or am I going wrong somewhere? It seems that the break even number would be around $170,000 to invest (generating right at $28k over four years in a 4% investment, the same as the loan interest). And if I'm correct, doesn't this speak to the value of a larger nucleus of $ to invest being more powerful than a smaller amount, simply due to the beauty of compounded interest?

    Comments would be most appreciated!



  • #2
    This has been discussed a bit recently, and a bit more extensively in the "value of liquidity" thread. I'd go there.


    • #3
      Zaphod you are correct, didn't read the liquidity post prior to starting this new thread but we are talking about very similiar issues. Hard to overemphasize also the psychological benefits of having a nice (and growing) taxable account along the way to financial independence.

      Would be good to get WCI's take on this as well