Pay down student loans vs taxable account investing for student loan repayment

[TotallyBroke]

I was going to post this in the Podcast ideas thread, then I thought I'd ask it as a separate thread and hear from other people too.

A little background, then a question:

Finishing my first year as EM attending.  I've got $430K in student loans.  I've refinanced them (now all less then 5% interest).  I recently read a post on StudentLoanHero which discussed investing vs applying extra principle.  In all honesty (& realistically), it's going to take me longer than 5 years to pay them off completely.  Yeah, yeah, I'm sure a bunch of people would tell me to get gazelle intense, rice and beans, yada yada yada.  The wife and kids aren't on board with that completely.  Costs are realistically down as far as they are going for the time being.  I know, I know.  No need to badger me about this...  Really, I know.

I recently read a post by StudentLoanHero about investing versus paying down principle.  It got me thinking.  Average student loans are at 4.4% interest with all of them less than 5%.

So, I'm contemplating opening a taxable account that is only earmarked for student loans.  I pay minimums on the loans. Any extra money, I'll put in an aggressive fund like index small value growth or something.  I have a stable job so at the worst, I will keep making the minimum payments.  But, the second that account is big enough to pay taxes on growth and pay off student loans, I'll drain it and pay them off.  I know that is leveraging and frowned upon by Dave Ramsey.  What does WCI think?

I think I can tolerate the risk.  Obviously, I wouldn't touch that money during a bear market because it couldn't pay off the balance.  If I have to sit on it for an extra year or two, I guess I'd just be out the extra minimum payments it takes for the market to return.  On the other hand, I would be able to keep buying when low.

Is this a really bad idea?  Or a decent one as long as my financial situation can tolerate the risk? Am I just scheming and scamming myself?  Thanks in advance for any thoughts.

Maybe this would be a decent topic for a blog post or podcast episode...

[skidoc]

Personally I think both the interest rate and the principle are far too high to be doing anything but paying those off aggressively. Leveraging investments at 5% doesn't seem like a great idea. Plus you will have capital gains tax. I would take any extra (after tax-deferred and backdoor roth) and put it straight to your loans.

[ENT Doc]

This proposal is really just a decision to go after the positive side of net worth rather than the negative.  Thus, it all depends on whether you can beat out the known rate of decline (4.4%) with your investments.  I don't like this plan.  If you're going to be aggressive, why not just put it all on emerging markets?  Are you comfortable with that?  Why not?  Also, you pay tax along the way (div) AND you pay tax when you sell it (CG) in this theoretically prosperous scenario to pay off the loan.  I would look at it like this - would you diversify your investments into a fixed income investment that would guarantee you 4.4% a year, especially in this environment?  I would.

[TotallyBroke]

I looked at emerging markets.  Looking at the track record of small cap value growth (VISGX) versus Emerging markets (VWO), it looks like the small cap has a better track record.  I know past returns don't predict future returns, but that's what I based it on.

With regard to the taxes, wouldn't it just be 15% of earnings that get taxed as long as I hold them for a year?  As understand it (and I could be wrong), that means if I make 10% growth per year, I'm really only making 8.5% real after tax growth.

Is there any point (aka low enough interest rate) where doing this would make sense?  Or am I just crazy and grasping at straws?

[Peds]

Go hard on the loans. Good luck.

[lucas]

4.4% is too steep to divert into a taxable imho.

We had around 560K (this was 6 yrs ago) and paid off all the loans that were above 2.75% before starting our taxable.  When we had the remaining 180K at 2.75% I split the difference between investing taxable and paying off the loans.  Had 30K left 1 month ago and decided to just pay it off and rid myself of the burden.  It.  feels.  amazing.

I vote forget the taxable. At least for now. If the market crashes you can always adjust.

 

[hightower]

That balance is too big to just be paying the minimum in my opinion.  Have u looked at what those loans will cost you with interest if you don't pay them off quickly?  It will be a very big number.  And that's money you have to earn still.  Don't get me wrong, I'm totally fine with holding on to some debt and padding your taxable...but 430k is a lot of debt.  FWIW I have 100k at 2.6% that I'm only making minimum payments on while I contribute to a taxable instead of paying it off early.  But, any higher than that would make me really uncomfortable personally.  And 4.4% would bother me a lot too.  For comparison, I have a car loan of 30k at 3% and it REALLY bothers me.  I have to keep reminding myself that it's not that bad while my taxable account grows.  For full disclosure, I also have a couple of credit cards with 0% interest for 21 months that I used to pay the last of my high interest student debt (27k) and the down payment on my car (14K).  Even though I'm not paying any interest on those balances right now, they are still debt and they still bother me because I know I haven't earned the money to pay them off yet.  My original plan was to just keep transferring the balances to new 0% interest cards and making minimum payments until they were gone, but I'm finding that I don't like having that hanging over my head even though I'm putting money into a taxable instead.  My point is, that debt might start to bother you more than you think even as you're seeing your taxable account grow.

If I were you I would pay down the loans to a more manageable level first (<100k?).  You have to pay that money back eventually anyway.  Your net worth will still go up if you do it now and you'll save yourself a lot of money by doing it sooner rather than later.  The problem with taxable accounts is that they can shrink all of the sudden when the market goes down again.  It might not feel good to know that your taxable account just dropped by 50% value, but your student loan balance is still super high.

Just make sure while you're paying the loans down that you're also maxing your 401k and a backdoor roth each year.

[TotallyBroke]

Just to clarify, the taxable account would be for the sole purpose of paying down student loans.  I don't have a taxable account right now.  I will not be saving anything in a taxable account for retirement until I am debt free (except maybe for mortgage) and maxing out all tax advantaged options.

[MaxPower]

Another vote for just paying down the loans aggressively instead of complicating life. Would you currently borrow money at 4.4% interest to invest in this market? I know I wouldn't.

I get that you think this is a no brainer to do, but there are plenty of pitfalls here. If I had that much debt at that high of an interest rate I would have trouble sleeping at night.

[hightower]

TotallyBroke wrote:

Just to clarify, the taxable account would be for the sole purpose of paying down student loans.  I don’t have a taxable account right now.  I will not be saving anything in a taxable account for retirement until I am debt free (except maybe for mortgage) and maxing out all tax advantaged options.

Click to expand...

I have to be honest, I don't think that's wise.  Aggressively investing money and saying it's ear marked for student loan repayment might not work so well if the market doesn't behave the way you're hoping.  Remember, if you put a bunch of money in that account you can't sell those investments for at least a year or you'll get hit with higher taxes on short term capital gains.  What will you do if you bust your butt all year and accumulate say 100k in that account and then the stock market drops by 50% before you get a chance to use it to pay off your loans?  That would hurt bad.  Or what if those investments have a bad few years and only grow at 2% or even -2%?
It would be much smarter to just start making big payments each month to those loans.  If you feel like you're missing out on the chance to invest some money, then you could do a little of both.  For example, if you have say 8k extra per month to use for this, why not take 6k of it and pay off loans and take the other 2k and put it in a taxable and let it grow?   It's best to buy and hold if you're going to invest.  Your plan sounds like you'd be relying on market timing to pay your student loans off and potentially be tempted to sell too early.  You'd be obsessing over the market wondering if you need to sell now every time the market drops a little to avoid a big loss.  You're setting yourself up for a buy high, sell low scenario.  Meanwhile the loans will be accumulating interest at a guaranteed 4.4%.  If I were you I'd take the guaranteed return of 4.4% and pay off those loans.

[DoubleMDs]

$430K? Pay the loans, pay the loans, pay the loans. Do not let yourself get comfortable with that debt, even if you're saying you'd use the taxable to pay them off later. The interest on that amount alone will likely negate any net positive gains.

[FCP]

I have 301k in loans (I paid about 50k of this during residency), and am graduating fellowship in a few weeks.  Starting next mo, I will be investing 35k/mo in taxable and 5k/mo in tax deferred accounts, and continuing to pay 5.4k/mo on my loans (5 yr repayment plan).  So, I am doing something similar to what you propose, but not to quite the extent you are envisioning.

I have many good reasons for why I am doing things this way:

 

1. It is my understanding that loans are forgiven upon death or disability; so if you spend 1 yr diverting all your income to pay them off, and get disabled/die, then you'll have zero in the bank/investments to give to yourself/heirs if you paid them off.

2. Historically, investing in the S&P500 will provide greater returns than what the interest rate on your loan is; so if that remains consistent in the future, then you will end up better off.

3. I like the freedom that hundreds of thousands in cash/investments provides.

 

Summary:  As long as you plan to pay off your loans in 5 years or less, and as long as you continue to live like a resident until you pay off your loans, use as much excess cash as you want toward your taxable account.  Stretching the loans further than 5 years isn't worth it to me; but you may win out on such a plan; it's a small gamble.

[DMFA]

You're EM. Why should it take you longer than 5 years to pay $430,000 in loans?

EM makes about $300k at least, right? 5-year fixed at 3.375% through SoFi would be $93,580/year, and assuming you're tax-efficient (maxing pretax retirement) leave you with about $10,000/month after tax and loans to live off.

That being said, purely from a mathematical perspective, student loans are simple amortizing debts; the only "gain" you get from paying them early is avoidance of finance charges.

$430k at 4.4% over 10 years, assuming a normal amortization schedule, would cost you at most $102,290 over that span, or 23.8% of the principal, which annualized over 10 years (1.238 ^ [1/10]) would be 2.16%. So any money that you would invest as opposed to paying your loan would have to beat that number. A shoot-from-the-hip estimate of what it would take in compounding gains to beat the loss in finance charges of a simple amortizing debt is *half* the debt's interest rate, because the principal which bears interest is getting smaller at a near-linear rate. It grinds my gears when people say an X% simple amortizing debt is a "guaranteed X% gain." That's bad math.

...back to a 2.16% compound gain...not a lot, is it? Seems like a no-brainer to let the loans go, right? I wouldn't jump to that. That assumes that every dollar you're not putting into your loans is going into an investment account that *will* beat it. Yes, it's likely to beat the low 2s, but if your loans are being left to linger, are you *really* going to use every single dollar to invest? That complacency leads a lot of debtors to take their eye off the ball and end up spending money otherwise, including on depreciating and consumable expenses like cars, while still being in the hook for the interest, defeating the leverage argument. This is why Dave Ramsey, as often as he is wrong about several mathematical concepts, is relevant: the mindset around the ubiquity of debt is one of the hardest things to overcome.

And even aside from debtor psychology, having very large debt is a financial problem that goes beyond simple net worth calculation. You have to take into account more than just what's going to result in the highest percent gain over time. Do you want a mortgage? What about a business loan? Maybe a car? (blasphemy, lol) Having debt in the hundreds of thousands is a big obstacle to those, even if you've got a big brokerage account. It also doesn't account for the risk of losing income while in debt, in which case you can really get screwed, especially if you're not properly insured...

So yes, if you are truly using leverage and investing every dollar which could otherwise go to eliminating debt, and only focused on overall net worth, then your mathematical argument is correct. There are other factors that cause that to be a suboptimal idea, though, which is why most veterans of a financial board like this one would caution you against letting large debts linger.

[DMFA]

FCP wrote:

I have 301k in loans (I paid about 50k of this during residency), and am graduating fellowship in a few weeks.  Starting next mo, I will be investing 35k/mo in taxable and 5k/mo in tax deferred accounts, and continuing to pay 5.4k/mo on my loans (5 yr repayment plan).  So, I am doing something similar to what you propose, but not to quite the extent you are envisioning.

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You mean to tell me you're investing $420,000 of after-tax dollars every year, while putting another $65,000 of after-tax dollars to loans? Half a million after-tax dollars not dedicated to living, right out of fellowship?

...I went into the wrong field.

[FCP]

DMFA wrote:

FCP wrote:

I have 301k in loans (I paid about 50k of this during residency), and am graduating fellowship in a few weeks.  Starting next mo, I will be investing 35k/mo in taxable and 5k/mo in tax deferred accounts, and continuing to pay 5.4k/mo on my loans (5 yr repayment plan).  So, I am doing something similar to what you propose, but not to quite the extent you are envisioning. 

Click to expand…

You mean to tell me you’re investing $420,000 of after-tax dollars every year, while putting another $65,000 of after-tax dollars to loans? Half a million after-tax dollars not dedicated to living, right out of fellowship?

…I went into the wrong field.

Click to expand...

If I told you I was a psychiatrist, would that boggle your mind further?  Because I am.  lol.