Inheritance- Loan payback vs investing

[estrouse1]

Hi everyone,

New to the message board but have enjoyed reading the blog from time to time.

I am a current dental resident, earning a salary of about 50k this year. I have 180k in education debt from dental school. I am entering a specialty residency this summer which is a 3 year tuition based program (estimate 75k per year for tuition plus living expenses).

I recently unexpectedly inherited money from a relative. My parents were kind enough to give me about 180k in order to pay off my loans, which are at 5-6%. I have no current student loan payments as they are using my 2017 income of zero. I hope to open my own practice or buy in soon after finishing my residency.

My parents want me to use to the money to pay of my loans and rid myself of the debt. I wanted to get the advice and opinions of some of you on the board here on what you would do in terms of just paying off the loan, paying off a large chunk and investing/saving some. My plan was to pay off 100-120k of my debt, max my Roth IRA, and hold on to the rest in some form. Please let me know some of your thoughts!

[Peds]

sounds good. i dont think it has to be 100% of anything. saving some cash for an EF is also a good idea.

[hightower]

Pay it all off!  Your parents are giving you the money for that purpose.  Don't be tempted to do anything else with it.  You'll be very glad later on that you don't have debt to deal with.  You're very very very fortunate!

[Going Under]

There are some great articles here about what to do with a windfall, and in general, the idea is to have and follow an investor policy statement/investing personal statement, paying off loans and filling up accounts in whatever order you already have specified. Consider paying off loans as a guaranteed return at whatever interest it's at, and that's hard to beat. Not to mention the psychological freedom of being out from under the loans. Maybe arguing for maxing out Roth during a low income period of life is reasonable before paying off loans, but honestly that's a small percentage of the money we're talking about here. And if you don't have an emergency fund, that would be important too. Other than that, I can't imagine you'll do much better than paying off the loans, and if this affects your relationship with your parents, even harder to argue.

So you have $180k in loans, is that $75k a year more loans or a salary? If it's more loans, than I'd say even more just use it all towards loans. And when you consider the debt you'll go into to start or buy into a practice, I'd really focus on getting that debt down. I may be wrong, but I think often loan officers look at a debt to income ratio when looking to lend, and in that sense lowering your debt may have more significance than increasing your assets with the same lump sum.

[DMFA]

Going Under wrote:

Consider paying off loans as a guaranteed return at whatever interest it’s at, and that’s hard to beat.

Click to expand...

Mathematically that's false because you're comparing a time-limited simple amortizing debt to an open-ended compound gain. In lump sums, it's more like half.

Still, though, if you could guarantee me 3% and then let me put whatever I'd have put toward the loan into a compounding investment, it's definitely worth taking, depending on one's risk tolerance.

[MPMD]

1. Roth for however many years you have left in training

2. $20k efund

3. All the rest to loans.

 

Just my 2c.

[Going Under]

DMFA wrote:

Going Under wrote:

Consider paying off loans as a guaranteed return at whatever interest it’s at, and that’s hard to beat.

Click to expand…

Mathematically that’s false because you’re comparing a time-limited simple amortizing debt to an open-ended compound gain. In lump sums, it’s more like half.

Still, though, if you could guarantee me 3% and then let me put whatever I’d have put toward the loan into a compounding investment, it’s definitely worth taking, depending on one’s risk tolerance.

Click to expand...

Thanks for the correction! It felt fishy as I wrote it, but I now realize I was forgetting you can't compare simple to compound as I was trying to. Honestly I'm still trying to wrap my head around it now, and the Googling I've done so far hasn't yielded a good explanation of the comparison, do you have a resource you can point to for more clarification? I guess I always thought the conventional wisdom/rule of thumb was if you can get a return better than your debt interest, it makes financial sense to invest for the return (ignoring behavioral stuff) but that seems to not actually be the case mathematically

[DMFA]

Debts have what is called an amortization schedule, that is, a predefined term, interest rate, and payment. This means that, assuming one sticks to the schedule and pays on time, there is an exact amount of finance charges (interest accrued) that will occur over this time period. The principal on which the interest accrues monthly is ever-decreasing. There is basically a "maximum loss" that you can prevent by paying over the schedule.

On the other hand, the principal on which your investment accrues interest is growing because it compounds interest-upon-interest (assuming it's going up, of course).

Say you have $100k debt at 5% over 10 years. Plugging that into the annuity formula, 120 payments of $1060.66, total paid $127,278.62 over 10 years, a "loss" of 27% over 10 years, 1.273^(1/10) = 2.44%. The most you can "gain" is the preventing of that interest from accruing.

You have $100k sitting around. You invest it and make 5% a year on it. You have 100,000 · 1.05^10 = $162,889. Sell it at 15% LTCG, you make 62,889 · 0.85 = $53,456

Now, say you keep that money in your investment account, pay the minimum on the debt, you're up by $62,889 gains - 27,279 interest paid = $35,610 if you don't sell, and $26,177 if you do.

Now, here's the kicker, and here's what people who have the means to pay debt *and* invest do. Say you *did* pay it all off at once, and instead invested that $1,060.66/mo you'd have paid to the debt for 120 periods and earned 5% compound annual growth: you'd come out on top to the tune of $163,726 (though $127,279 of that is principal instead of the original $100,000), earning $36,447 in the process. So, while you did earn more absolute, you ended up putting more in and had a lower percent aggregate return on principal...but it was money that would be flowing out of your monthly cash anyway.

You see the tiny difference here ($837 over 10 years...c'mon, right), but that's at a higher debt interest rate than one ought to have and a lower rate of gain than one might expect. However, the purpose of the exercise was to compare and contrast simple and compound and to demonstrate a similar maneuver which a disciplined investor of means might be able to take: pay the debt and DCA in the monthly payment on it. This is one more reason why wealthy people don't finance things like cars; they can just be their own bank and pay themselves back every month.

[LasixDrip]

If you were given money to specifically pay off your loans, then pay off your loans. It’s a wonderful gift you’ve been given, congratulations!

[StarTrekDoc]

+1 with lasix's POV.  Payoff debt as was the money was intended.  You'll have your own dollars sooner to do with what you want.....and remember this when you're the primary caretaker of the generations above and below.

 

[DMFA]

Also remember you don't know what the market will do; no guarantee there, esp over the short term. While you might possibly have earned more in the market, you're certainly on the hook for your debt, you're never wrong to pay it.

Also, the pay aggressively vs not argument *only* applies if you're *actually* investing the sum in question. I've heard of people not paying debt because it's "low interest," but spending the sum in question on consumable goods or something. That's just choosing which way one wants to lose money.

[Hank]

Lenders want to see $50-100K in your checking account before they’ll lend you a half million for a practice acquisition loan. Oddly enough, they’d rather see $350-450K in student loan debt and $100K in your bank account than lend to someone two years out of dental school or a specialty residency who just aggressively paid off $250-350K in student loan debt but only has $20-30K in the bank.

(Members of this forum probably can guess who has the higher net worth and who’s been more fastidious about paying back her debts, but that’s not the way the dental lenders at the banks tend to see it.)

Talk with dental lenders in your area. See what credit score, work experience, and balance sheet they’re looking for when they lend for a practice buy in or buy out. Keep checking in with them about once a year, because lending standards can change. Also check with folks a few years ahead of you in your program to see how things go when they buy their practices.

The right answer may not be to put 100% of this windfall towards your student loan debt.

[AlexxT]

DMFA wrote:

Mathematically that’s false because you’re comparing a time-limited simple amortizing debt to an open-ended compound gain. In lump sums, it’s more like half.

Click to expand...

 

DMFA wrote:

Debts have what is called an amortization schedule, that is, a predefined term, interest rate, and payment. This means that, assuming one sticks to the schedule and pays on time, there is an exact amount of finance charges (interest accrued) that will occur over this time period. The principal on which the interest accrues monthly is ever-decreasing. There is basically a “maximum loss” that you can prevent by paying over the schedule. On the other hand, the principal on which your investment accrues interest is growing because it compounds interest-upon-interest (assuming it’s going up, of course). Say you have $100k debt at 5% over 10 years. Plugging that into the annuity formula, 120 payments of $1060.66, total paid $127,278.62 over 10 years, a “loss” of 27% over 10 years, 1.273^(1/10) = 2.44%. The most you can “gain” is the preventing of that interest from accruing. You have $100k sitting around. You invest it and make 5% a year on it. You have 100,000 · 1.05^10 = $162,889. Sell it at 15% LTCG, you make 62,889 · 0.85 = $53,456 Now, say you keep that money in your investment account, pay the minimum on the debt, you’re up by $62,889 gains – 27,279 interest paid = $35,610 if you don’t sell, and $26,177 if you do. Now, here’s the kicker, and here’s what people who have the means to pay debt *and* invest do. Say you *did* pay it all off at once, and instead invested that $1,060.66/mo you’d have paid to the debt for 120 periods and earned 5% compound annual growth: you’d come out on top to the tune of $163,726 (though $127,279 of that is principal instead of the original $100,000), earning $36,447 in the process. So, while you did earn more absolute, you ended up putting more in and had a lower percent aggregate return on principal…but it was money that would be flowing out of your monthly cash anyway. You see the tiny difference here ($837 over 10 years…c’mon, right), but that’s at a higher debt interest rate than one ought to have and a lower rate of gain than one might expect. However, the purpose of the exercise was to compare and contrast simple and compound and to demonstrate a similar maneuver which a disciplined investor of means might be able to take: pay the debt and DCA in the monthly payment on it. This is one more reason why wealthy people don’t finance things like cars; they can just be their own bank and pay themselves back every month.

Click to expand...

 

If this were true, then you could earn a lot of money by lending yourself money.

Loans don't compound because you pay off the interest each month.  Investments won't compound if you spend the interest each month.  If you invest the same amount at the same interest rate as a loan, your investment can't compound because you have to use all the earned interest in order to pay the loan interest.

Then you have to pay down  the monthly principal payment.  That money comes from the invested principal.  Now you're left with a smaller loan and a smaller investment.

At the end of the loan period, if both interest rates are the same, you will break even.  No loan, but no investment.

Of course, you can come out ahead if the investment return is higher than the loan interest rate, but that's a different issue.

Try this with a loan calculator ( look at the monthly payments and total paid ) and an investment calculator ( investing the monthly payments and investing the lump sum ) and see what you get.  I have done this.  There may be slight differences due to differences in the calculators, but you should break even if the interest rates are the same.

What is confusing to many people is the term "compounding".  We use this to mean the same thing as reinvesting our gains, but when it comes to loans, the only true use of the term is when describing interest rates on bank CDs, where the interest is often divided into two parts, which allows the interest to compound, giving you a slightly higher rate. i.e. you earn 2% twice a year, vs 4% once a year, so your APY is slightly higher than the nominal 4%.

Investments returns are often given as CAGR, Compound Annual Growth Rate ie the rate at which you can characterize the returns AS IF they were compounding.   But they don't really compound.  The returns are reinvested over several years and a number is calculated.  Similarly, loans don't compound because you pay off the interest each month.

When you buy a bond, the interest is simple.  It only compounds if you reinvest it.  The same is true for stocks.  If you spend the dividends and appreciation, it won't compound.  A loan will compound also, if you choose not to pay the interest and don't pay off principal.   If you do pay them off, they are coming out from your investments, or from money that you would have invested.

OP:  I would pay off the loan, because paying it off is exactly the same as holding a guaranteed bond at 5-6%.  Most investors have bonds paying 2%.   Paying off your loan is a no-brainer.   The stock market might get you more, but the risk is not worth the extra 1 to 2 % you might get.  Not to mention the fact that paying off the loan at 6% is giving you a "tax free" 6% return. Most of this money would go into a taxable account, so your effective yield would be less than what you might earn.

[q-school]

opening your own practice is expensive.

income will fluctuate wildly (i assume).

you will have to come up with a lot of overhead.   you will draw your salary for some time without a steady predictable revenue stream.

if you want to start hiring others underneath you, they will want income guarantees.

if you are headset on starting your own practice, then consider holding on to the money.  can't really invest in the stock market either if you need it in a short time frame.

good luck.

 

 

[Zaphod]

AlexxT wrote:

Loans don’t compound because you pay off the interest each month. Investments won’t compound if you spend the interest each month. If you invest the same amount at the same interest rate as a loan, your investment can’t compound because you have to use all the earned interest in order to pay the loan interest.

Click to expand...

There is nothing wrong with paying down debt if thats your informed choice, and Im not advocating for putting it all in the market, just for the broader eductational purposes. That said...

This is just not true in any way shape or form. This isnt how loans work at all. Its a different formula. I know I've gone over the details here before, and even though @DMFA has also been putting in the work, it still seems a lot of misconceptions on the fundamentals abound.

The whole rest of your post is just expounding upon the base of not quite understanding these processes and leads to a decision making process that chooses actions based on misunderstanding consequences. This is the reason I push back when people say things like 'guaranteed return' etc...not because paying off debt is always wrong, not at all, its because people dont truly understand whats happening and make a mental model that may be detrimental long term or not in line with their goals based on an algorithm with poor underlying assumptions.

Here are the formulas, they are very different. Its not some way of speaking its a literally different method of calculation that has very real impacts on results.

Simple interest: I=prt

I=interest

p=principal

r=rate

t=time

Compound interest: C=p[(1+r)^n-1]

c, p, r=same as simple

n=number of periods

 

Punching in any same condition will immediately show the differences and that they are not the same. This is with one period. Take in the defined term in a loan vs. an open ended period with compounding and things get super obvious.