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Paying off loans quickly in near future versus saving/investing

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  • Dicast
    replied
    Easy answer is to refinance to the lowest rate you can get.  I go back and forth myself on how fast to payoff loans and I'm currently in the early payoff group.

    There are a few pros to early payoff other than feeling great about not having debt.

    1. Money is no longer available in case you get sued.  A taxable account will be accessible (although not likely utilized if you carry appropriate insurance).

    2. Improved cash flow.  Need less for emergency fund.  Improved freedom should you want to change jobs or have extended time unemployed.

    3. Paying off a loan may be easier before you spend a couple years with attending lifestyle creep.

    4. You are a market timer and think the market will tank.  You won't lose money should the market tank and you'll have more to invest if it does.

    Cons:

    Pretty sure it will cost you money in the long run, on average to payoff early.

    If you refinance at 3.5% for 5 years you'll be debt free in 5 years (which doesn't take long) and have a growing taxable account.

     

    Leave a comment:


  • Zaphod
    replied




    Zaphod, I already explained this to you in a previous thread.
    Look at it this way: if you borrow 100k at 7% from one person, and lend or invest 100k with someone else, you are going to break even. Just run the numbers and see for yourself. You are simply on opposite sides of the same transaction. Otherwise, no one would lend if borrowing somehow didn’t compound.
    If money compounds for the lender, how could it not be compounding for the borrower?
    Click to expand...


    You are again comparing a fixed cost that does not compound, not truly. Things can have the appearance of compounding and not be true compounding (mortgages, etc..). People here tend to conflate them when it isnt true. On a loan, you have a set amount of interest that is known before you sign the papers. The best you can do, with prepaying or paying all lump sum at once is avoid that number by a factor no greater than one, it is in no way open ended like an investment in the market. Even if you call over payment of principal a compounding effect (it is similar, but not the same as its principal not interest) you can only avoid a certain known amount of interest. If the interest is paid every month, it cannot compound because its not there to do so.

    I dont understand your example it makes no sense. If you borrow and lend at the same rate of course you dont make any money, its a mathematical tautology. If you were doing that you have to have a spread that is greater than your all in transaction costs.

    This is in no way comparable to investing it. Debt is again fixed and known (all costs are very obvious in the documents), it doesnt grow unless someone is missing payments. The market grows as a whole on average over time, that is how one makes money or keeps ever so slightly ahead of inflation. This is not the same transaction, and is the whole basis of capital markets and entrepreneurship and business.

    Money doesnt compound for the lender either, they again know the total amount they will receive as stated in the "cost of the loan" in the truth in lending documents. Thats not the point of selling debt, for them they hope its a low risk predictable income stream. They get more by increasing volume.

    Amortization makes this a couple levels more complex, but it is still not the same thing as actual, true compound interest (unless negative amortization). This is what we spoke about last time I believe. While you are compounding the effect of the the principal going forward by varying payment amount, and saving long term, that doesnt change the loan type to compound interest. Both of these things can be true. Unless the principal balances grows due to the interest being added to the loan it simply is not true compounding.

    Harry Sit has a nice article about this https://thefinancebuff.com/is-home-mortgage-simple-interest-or-compound-interest.html .

     

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  • AlexxT
    replied
    Zaphod, I already explained this to you in a previous thread.
    Look at it this way: if you borrow 100k at 7% from one person, and lend or invest 100k with someone else, you are going to break even. Just run the numbers and see for yourself. You are simply on opposite sides of the same transaction. Otherwise, no one would lend if borrowing somehow didn't compound.
    If money compounds for the lender, how could it not be compounding for the borrower?

    Leave a comment:


  • Zaphod
    replied





    Haha I wish I could see 140000 of loans is small.
    Click to expand...


    Well, I will trade you balances  

    Leave a comment:


  • Zaphod
    replied








    Not everyone is getting my point. I’m dumping money into Roth IRA and 401x accounts; that I’ve concluded is beneficial in the long-term. By paying off my loans rapidly *this* year, I’m going to sacrifice one year of contributions to a taxable account, therefore one less extra year of long-term compounded interest/growth.

    Sorry, but you’re making some fundamental mistakes in your understanding of how loans work.

    I suggest that you do the following:   Assuming a loan amount of 130k, go to an investment calculator and see what a lump sum investment of 130k at 6.8% would grow to in 10 years.  This will show you what your money would grow to if you decide to invest instead of paying off your loan.

    Then find out what your monthly loan payments would be for that same loan at the same interest rate. ( you  can use a mortgage calculator to find this out) Then go to the investment calculator and make that loan payment your monthly investment for the same 10 years at the same interest rate.  That will show you what that money would have grown to if you had invested that loan payment every month instead of paying off the loan.  You will realize that there is no difference between the two options if the interest rate is the same. The totals will be exactly the same, to the penny.

    This is because both the investment and the loan compound, even though this isn’t obvious for the loan ( the compounding takes the form of the extra principal payments you make each month).

    So there’s no intrinsic benefit of one choice over the other, assuming that the interest rate is the same.  However, since the loan 6.8% is guaranteed, but the market return is expected to be 7% but not guaranteed, getting the guarantee with the loan payment is a no brainer.  If I could get bonds with no chance of default ( ie like the loan repayment) I  would put every penny I had into those, and I generally don’t buy bonds at all.

    However, if you can refinance to a lower rate, that changes the decision, but even at 4% , or even 3%, I would pay off the loans.

     

    H
    Click to expand…


    Agree with this analysis. I have always been confused why people are so concerned about the loss of compounding interest on investments but not about the impact of additional compounded interest on loans when doing these analyses.

     

    To the OP: I would max out retirement accounts and then put all additional money towards loan repayments prior to investing in a taxable account. Still look at loan refinancing to get the interest rate lower. If not now, at least once you have your attending salary and will get the most favorable rate.
    Click to expand...


    Its because that math was the wrong approach to assess the difference. Interest on a loan that is being paid does not compound. If you pay by the terms there is a set amount of interest to pay, no questions or issues with that amount. Further, they can and should refi and make it even smaller.

    The OP has the correct view on it, long term. So remember, there is a huge difference between simple and compound interest.

    For example if the OP just puts in the average of the 3-5k per month extra he has and lets it grow at a CAGR of 2% then after 20 years not only will he have a large taxable balance over 1.1M dollars but the miniscule amount of interest he gained will be more than the total student loan amount. Obviously this get even more extreme if taken to 30-40 years or the interest rate is 4-6%.

    The loan has a fixed term and fixed amount of interest, and thats simple. It is not even set in stone at such a terrible rate and should be refinanced. Paying it off is a one time fixed amount event, its not bad, but its very limited.

    Investing has no set term and can go on for 50-60 years of your life and then be passed on to your heirs if you're so fortunate. It is also compound interest which means even a low nominal number can be powerful, especially over the span of your life.

    It is actually very simple. Look at the loan documents and see what the total interest is. See if not paying it off this year is going to set you back a ton, it wont.

    The reason the consensus is to pay off the loans on a site such as this is because this is part of the overall mindset of our type of people, it does not mean its the correct one. It is however a good overall view to not just have massive amounts of debt, but lets be honest that was not the trade off you asked about, you asked about this year in particular. However, mathematically, and for the long term due to factors I discussed in prior posts investing will end out on top, even with a totally crap return of 2%.

     

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  • shantster
    replied





    Not everyone is getting my point. I’m dumping money into Roth IRA and 401x accounts; that I’ve concluded is beneficial in the long-term. By paying off my loans rapidly *this* year, I’m going to sacrifice one year of contributions to a taxable account, therefore one less extra year of long-term compounded interest/growth.

    Sorry, but you’re making some fundamental mistakes in your understanding of how loans work.

    I suggest that you do the following:   Assuming a loan amount of 130k, go to an investment calculator and see what a lump sum investment of 130k at 6.8% would grow to in 10 years.  This will show you what your money would grow to if you decide to invest instead of paying off your loan.

    Then find out what your monthly loan payments would be for that same loan at the same interest rate. ( you  can use a mortgage calculator to find this out) Then go to the investment calculator and make that loan payment your monthly investment for the same 10 years at the same interest rate.  That will show you what that money would have grown to if you had invested that loan payment every month instead of paying off the loan.  You will realize that there is no difference between the two options if the interest rate is the same. The totals will be exactly the same, to the penny.

    This is because both the investment and the loan compound, even though this isn’t obvious for the loan ( the compounding takes the form of the extra principal payments you make each month).

    So there’s no intrinsic benefit of one choice over the other, assuming that the interest rate is the same.  However, since the loan 6.8% is guaranteed, but the market return is expected to be 7% but not guaranteed, getting the guarantee with the loan payment is a no brainer.  If I could get bonds with no chance of default ( ie like the loan repayment) I  would put every penny I had into those, and I generally don’t buy bonds at all.

    However, if you can refinance to a lower rate, that changes the decision, but even at 4% , or even 3%, I would pay off the loans.

     

    H
    Click to expand...


    Agree with this analysis. I have always been confused why people are so concerned about the loss of compounding interest on investments but not about the impact of additional compounded interest on loans when doing these analyses.

     

    To the OP: I would max out retirement accounts and then put all additional money towards loan repayments prior to investing in a taxable account. Still look at loan refinancing to get the interest rate lower. If not now, at least once you have your attending salary and will get the most favorable rate.

    Leave a comment:


  • AlexxT
    replied


    Not everyone is getting my point. I’m dumping money into Roth IRA and 401x accounts; that I’ve concluded is beneficial in the long-term. By paying off my loans rapidly *this* year, I’m going to sacrifice one year of contributions to a taxable account, therefore one less extra year of long-term compounded interest/growth.

    Sorry, but you're making some fundamental mistakes in your understanding of how loans work.

    I suggest that you do the following:   Assuming a loan amount of 130k, go to an investment calculator and see what a lump sum investment of 130k at 6.8% would grow to in 10 years.  This will show you what your money would grow to if you decide to invest instead of paying off your loan.

    Then find out what your monthly loan payments would be for that same loan at the same interest rate. ( you  can use a mortgage calculator to find this out) Then go to the investment calculator and make that loan payment your monthly investment for the same 10 years at the same interest rate.  That will show you what that money would have grown to if you had invested that loan payment every month instead of paying off the loan.  You will realize that there is no difference between the two options if the interest rate is the same. The totals will be exactly the same, to the penny.

    This is because both the investment and the loan compound, even though this isn't obvious for the loan ( the compounding takes the form of the extra principal payments you make each month).

    So there's no intrinsic benefit of one choice over the other, assuming that the interest rate is the same.  However, since the loan 6.8% is guaranteed, but the market return is expected to be 7% but not guaranteed, getting the guarantee with the loan payment is a no brainer.  If I could get bonds with no chance of default ( ie like the loan repayment) I  would put every penny I had into those, and I generally don't buy bonds at all.

    However, if you can refinance to a lower rate, that changes the decision, but even at 4% , or even 3%, I would pay off the loans.

     

    H

    Leave a comment:


  • jhwkr542
    replied




    By paying off my loans rapidly *this* year, I’m going to sacrifice one year of contributions to a taxable account, therefore one less extra year of long-term compounded interest/growth.




    I think you're missing the point some of us are making. The stock market is a fickle thing. Let's give you $140k in cash right now. Do you pay off the loans or invest?  If you pay off the loans, you have avoided the $9k in interest that year, so you've come out ahead that much. If you put it into a taxable and the markets are down 5% after that year (not even worst case scenario), then not only have you lost 5% of that $140k, but now you owe $149 on the loans.

    Yes, investing in tax-advantaged spaces is better because the growth on your money is tax-free, and you also get the reduction from your marginal tax rate now to your future marginal rate in retirement (presumed to be lower).

    The consensus is also to refinance from 6.8%. Like I said earlier, if you're worried about losing the ability to lower your payments if something happens in this short time interval, refinance with earnest.

    Leave a comment:


  • xilex
    replied
    Not everyone is getting my point. I'm dumping money into Roth IRA and 401x accounts; that I've concluded is beneficial in the long-term. By paying off my loans rapidly *this* year, I'm going to sacrifice one year of contributions to a taxable account, therefore one less extra year of long-term compounded interest/growth.

    Paying off loans now is a guaranteed return of 6.8%, I agree. But starting next year with a larger income I can pay off the loans quickly. Is sacrificing that one year of contributions worth more than paying off loans is my question. The general consensus so far seems like paying off loans instead of contributing to taxable account is more advantageous. I've seen calculations supporting contributing to tax-deferred/sheltered accounts first, however, so at least that is a settled argument.




    ...Like I said, he should be able to do both in short order as his principal is relatively small.

     
    Click to expand...


    Haha I wish I could see 140000 of loans is small.

    Leave a comment:


  • Zaphod
    replied




    Really cannot understand any other rational than to pay off your 6.8% debt first. This is a short term guaranteed return of 6.8% (you had stipulated 2 years for payoff). You will get no guarantee, short-term, that can beat 6.8%. If someone has an alternative, would love to see it here. As much as I am a proponent of a balanced equity portfolio (for the long term only and as the servant of a proper plan), there is no way you will get that kind of guarantee for a 2 year timespan.

    Once that is paid off, go for a taxable account and revel in your freedom from debt.
    Click to expand...


    I would refinance those loans, 6.8 is awful.




    So by this logic, op should pay as little towards loans as possible and invest the rest…?


    If math, terminal wealth, etc...is your only point of contention, but of course there are other considerations. Like I said, he should be able to do both in short order as his principal is relatively small.

    Mostly its just food for thought as to what your doing when prioritizing one thing over another. Just seems a lot of people really pound the pay down your mortgage etc...without realizing the trade offs. Always good to see the other side of things. Doesnt mean it has to change your opinion or actions.

     

     

     

     

     

    Leave a comment:


  • jfoxcpacfp
    replied
    Really cannot understand any other rational than to pay off your 6.8% debt first. This is a short term guaranteed return of 6.8% (you had stipulated 2 years for payoff). You will get no guarantee, short-term, that can beat 6.8%. If someone has an alternative, would love to see it here. As much as I am a proponent of a balanced equity portfolio (for the long term only and as the servant of a proper plan), there is no way you will get that kind of guarantee for a 2 year timespan.

    Once that is paid off, go for a taxable account and revel in your freedom from debt.

    Leave a comment:


  • jhwkr542
    replied
    So by this logic, op should pay as little towards loans as possible and invest the rest...?

    Leave a comment:


  • Zaphod
    replied







     

    While all correct, the 6.8% comes with zero risk.  The markets may be down the next 2 years, may be up, may be flat.  6.8% guaranteed simple interest isn’t bad.  You’d be gambling that the markets will return better in the 2 years.  Plus the peace of mind of having loans gone sooner and increased cashflow is not insignificant.

    I’d refinance the loans and pay them down.  If you think your job will be safe for another 2 years, there’d be very low risk of needing the federal benefits.  Use Earnest if you’re worried, which will let you change your repayment as you go if something happens.
    Click to expand…






    taxable still wins. You’re comparing simple to compound interest and a bounded vs. unbounded term with your debt dying a smidgen every year due to inflation. Its really an unfair fight. Its actually a simple to find out amount, you know the exact finance charges associated with your loans so that is your holding costs for those, all in. The only thing you can work with in investing is historical numbers +/- some discounting factor, etc…Basic premise aside from compound interest rates can be smaller than simple and come out far far ahead, is that the nominal loan payment will stay the same but due to inflation will actually be a smaller payment over time. As opposed to the investment which has historically increased purchasing power/out paced inflation over 20-30+ years. May not happen in the beginning years, but the longer out you go the more likely and locked in it becomes. Doesnt make it the right choice for you but mathematically its pretty obvious. Same thing applies to mortgage prepayment only much worse since rates are super low and tax advantaged.

    The deferment forbearance is nice, but low probability. As is the repayment options, and in reality quite a few private lenders have similar options.
    Click to expand…


    “taxable still wins” meaning putting money into investments now will have a potentially greater return years from now?

    jhwkr542: I’m not looking at the market in two years, I’m looking at the 20 year growth with contributions lost during this year and a little less over the next two years (the earliest years for compounding).
    Click to expand...


    Yes. That is true from a terminal wealth perspective. I have attached a couple graphs that demonstrate what inflation will do to todays 100 dollars and then what investing it has been historically and then for rolling 30 year periods since 1928. I would refinance those loans to a better rate unless you really think you wont be able to get a job.

    For the inflation graph you can see that each year your loan/mortgage payment gets cheaper in real dollars and anything you would be investing is buying less. For the investing graph you will see average, median, min and max values of return in the greater market. Minimum after 30 years was something like 851%. So by putting your loan payments as a priority instead of investing you are essentially prioritizing saving yourself from having to make a 50% off payment sometime in the future and avoiding growth of those dollars by 8.5x.

    Hopefully at some point you have enough money coming in you dont really have to feel like you need to make a choice, and thats likely if you live like a resident for the first few years. I would prioritize (and am) building up a nice nest egg, emergency fund, etc...in the beginning and not hurting liquidity/cash flow at the beginning. After a few years of doing that you probably will be able to crush the loans if you wanted, buy the doctors house, etc...

    Leave a comment:


  • Zaphod
    replied




     




    taxable still wins. You’re comparing simple to compound interest and a bounded vs. unbounded term with your debt dying a smidgen every year due to inflation. Its really an unfair fight. Its actually a simple to find out amount, you know the exact finance charges associated with your loans so that is your holding costs for those, all in. The only thing you can work with in investing is historical numbers +/- some discounting factor, etc…Basic premise aside from compound interest rates can be smaller than simple and come out far far ahead, is that the nominal loan payment will stay the same but due to inflation will actually be a smaller payment over time. As opposed to the investment which has historically increased purchasing power/out paced inflation over 20-30+ years. May not happen in the beginning years, but the longer out you go the more likely and locked in it becomes. Doesnt make it the right choice for you but mathematically its pretty obvious. Same thing applies to mortgage prepayment only much worse since rates are super low and tax advantaged.

     

    The deferment forbearance is nice, but low probability. As is the repayment options, and in reality quite a few private lenders have similar options.
    Click to expand…


     

    While all correct, the 6.8% comes with zero risk.  The markets may be down the next 2 years, may be up, may be flat.  6.8% guaranteed simple interest isn’t bad.  You’d be gambling that the markets will return better in the 2 years.  Plus the peace of mind of having loans gone sooner and increased cashflow is not insignificant.

    I’d refinance the loans and pay them down.  If you think your job will be safe for another 2 years, there’d be very low risk of needing the federal benefits.  Use Earnest if you’re worried, which will let you change your repayment as you go if something happens.
    Click to expand...


    Never said it made it the right decision. There are lots of other reasons besides peace of mind that paying off the loan is nice as well (and its not a large sum so its not that it wouldnt be easy), freedom, options, etc... You always have options with a taxable account, if you change your mind on debt vs. investing you can always just pay it off instead.

    However, you cant look at it in the next 2 years kind of thing, that is entirely the wrong short term type of thinking. If you were really analyzing it in this matter, you would only be justified if greater terminal wealth was the goal, 20 or 30 years later. Not 2, or even 5-10. Its a much more long term time/inflation arbitrage than some quick get rich scheme.

    Leave a comment:


  • xilex
    replied




     

    While all correct, the 6.8% comes with zero risk.  The markets may be down the next 2 years, may be up, may be flat.  6.8% guaranteed simple interest isn’t bad.  You’d be gambling that the markets will return better in the 2 years.  Plus the peace of mind of having loans gone sooner and increased cashflow is not insignificant.

    I’d refinance the loans and pay them down.  If you think your job will be safe for another 2 years, there’d be very low risk of needing the federal benefits.  Use Earnest if you’re worried, which will let you change your repayment as you go if something happens.
    Click to expand...






    taxable still wins. You’re comparing simple to compound interest and a bounded vs. unbounded term with your debt dying a smidgen every year due to inflation. Its really an unfair fight. Its actually a simple to find out amount, you know the exact finance charges associated with your loans so that is your holding costs for those, all in. The only thing you can work with in investing is historical numbers +/- some discounting factor, etc…Basic premise aside from compound interest rates can be smaller than simple and come out far far ahead, is that the nominal loan payment will stay the same but due to inflation will actually be a smaller payment over time. As opposed to the investment which has historically increased purchasing power/out paced inflation over 20-30+ years. May not happen in the beginning years, but the longer out you go the more likely and locked in it becomes. Doesnt make it the right choice for you but mathematically its pretty obvious. Same thing applies to mortgage prepayment only much worse since rates are super low and tax advantaged.

    The deferment forbearance is nice, but low probability. As is the repayment options, and in reality quite a few private lenders have similar options.
    Click to expand...


    "taxable still wins" meaning putting money into investments now will have a potentially greater return years from now?

    jhwkr542: I'm not looking at the market in two years, I'm looking at the 20 year growth with contributions lost during this year and a little less over the next two years (the earliest years for compounding).

    Leave a comment:

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