Is Paying Off Loans Fastest Always Best Idea?

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hds2388
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Is Paying Off Loans Fastest Always Best Idea?

Postby hds2388 » Sat Apr 20, 2013 4:39 pm

So for a long time, I had held the TLS-approved wisdom that paying off your loans the fastest is the best idea because it is challenging [(impossible)] to find an investment that outpaces the interest rate on loans. So apart from having a life-raft of savings (6-12 months of living expenses), all the money you want to save or "invest" should be invested in loans.

However, I recently went to a presentation by a student loan repayment consultant my school hosted. He seemed pretty legit and had a PhD in something relevant. His advice was that it is not always best to pay off your loans as fast as possible.

Instead, he suggested that you pay off your loans at a (self-defined) comfortable rate that you can afford and puts a dent in your loans (if possible); he had ways of figuring out a good personal repayment schedule based on income. Simultaneously, he suggested that instead of diverting all of your remaining money into loans, it was smarter to save for a down payment on a home/condo/apartment. His reasoning was that, considering the following, it was, in certain circumstances, a better financial investment because one:

(1) Gains the advantages of building equity with monthly living expense payments, as opposed to paying rent
(2) Gains the tax advantages of mortgages (mortgage interest deduction)
(3) Develops equity earlier (which he contended was better, even if it meant having more debt on the opposite side of the balance sheet)

What does everyone think?

I'll admit I was somewhat swayed.

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cinephile
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby cinephile » Sat Apr 20, 2013 5:01 pm

I wouldn't feel comfortable unless I had enough savings to live off of for 2 years (plus travel/moving expenses to other cities to find work). Other than that, I can't comment since I don't really know. All I can say is that we had a consultant like this come to our school too, and the effect was to assure students not to worry about their loans and borrow as much as you like - IBR will erase it all someday.

hds2388
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby hds2388 » Sat Apr 20, 2013 5:08 pm

cinephile wrote:I wouldn't feel comfortable unless I had enough savings to live off of for 2 years (plus travel/moving expenses to other cities to find work). Other than that, I can't comment since I don't really know. All I can say is that we had a consultant like this come to our school too, and the effect was to assure students not to worry about their loans and borrow as much as you like - IBR will erase it all someday.



Yeah, I mean, I'm planning on saving up a decent amount to live on should I lose my job, no matter what. So I'm with you in that regard.

This was a workshop really geared for 3Ls about to start repayment-- it definitely wasn't a "Borrow lots of money! It's Free!" seminar.

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thesealocust
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby thesealocust » Sat Apr 20, 2013 5:13 pm

The conventional wisdom here reflects one financial fact: risks and returns are generally correlated to one another bot both are impossible to predict. Paying down loans is roughly equivalent to a 6-9% return on the dollars you spend paying down the loans, and that return is "risk free" in the sense that you know exactly what your earnings/savings will be when you allocate the dollars (not so for stocks, and somewhat less so for bonds in a variable interest rate environment).

So you can prove that you experience a higher risk adjusted rate of return putting a dollar towards an 8.5% interest rate loan than putting a dollar in a stock market index fund. The main take away is that by and large your dollars earn more for you paying down debt than investing. Groovy.

But dollars do have uses other than providing returns. The biggest is liquidity: running out of money can make life painful, expensive, or expensive and painful. Hence the utility of emergency funds which will obviously otherwise be "returning" less than an investment. So there are lots of valid things to use large sums of money for other than paying down debt, it's just important to realize it would be foolish to try and beat the rate of return of debt.

However, the financial advice in the OP is BADLY oversimplified and potentially dangerous. Equity and mortgage tax advantages are nice, but the sales pitch there is way too hard.

Renting vs. buying is very complicated. Equity is nice, but equity is MUCH more expensive than its sticker price. Comparing a mortgage payment to a rent check can make your eyes pop at the benefits of buying compared to renting. Then your roof breaks or a pipe bursts and you have to cover it yourself. And for some reason home owners insurance puts you back much further than renters insurance. Oh and property taxes - the list goes on.

Over very long periods of time buying can indeed be the superior choice, but it usually takes years, and a lot of the advantages are lost if you need or want to move - transaction costs put an enormous amount of financial friction into the calculations that eat away benefits you might otherwise have.

None of this is to say that renting is BETTER than buying, but buying isn't so obviously superior that it's an obvious investment to target.

This is a decent tool: http://www.nytimes.com/interactive/busi ... .html?_r=0
Last edited by thesealocust on Sat Apr 20, 2013 5:14 pm, edited 1 time in total.

M458
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby M458 » Sat Apr 20, 2013 5:13 pm

Just something to keep in mind: often renting makes more sense over buying a home.

Play with this: http://www.nytimes.com/interactive/busi ... lator.html

And also take into account the fact that once you buy a home, your geographic flexibility decreases significantly.

ETA: scooped by thesealocust!

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Mick Haller
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Mick Haller » Sat Apr 20, 2013 5:17 pm

The interest rate on student loans is fairly high... 6.5% for federal and higher for private. I will be paying mine off as fast as possible.

I don't think housing is going to boom again, and I don't see it as a great investment in the next 10 years. In middle America houses are always going to be cheap for professionals. Home values in coastal markets are too high and/or too volatile.

EDIT: plus all the rent vs. buy analysis above. Advising everyone with a pulse to jump into a mortgage now now now is so 2005. Millenials will not have the spending power or the savings to absorb all the boomer housing stock anytime soon.

hds2388
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby hds2388 » Sat Apr 20, 2013 5:21 pm

thesealocust wrote:The conventional wisdom here reflects one financial fact: risks and returns are generally correlated to one another bot both are impossible to predict. Paying down loans is roughly equivalent to a 6-9% return on the dollars you spend paying down the loans, and that return is "risk free" in the sense that you know exactly what your earnings/savings will be when you allocate the dollars (not so for stocks, and somewhat less so for bonds in a variable interest rate environment).

So you can prove that you experience a higher risk adjusted rate of return putting a dollar towards an 8.5% interest rate loan than putting a dollar in a stock market index fund. The main take away is that by and large your dollars earn more for you paying down debt than investing. Groovy.

But dollars do have uses other than providing returns. The biggest is liquidity: running out of money can make life painful, expensive, or expensive and painful. Hence the utility of emergency funds which will obviously otherwise be "returning" less than an investment. So there are lots of valid things to use large sums of money for other than paying down debt, it's just important to realize it would be foolish to try and beat the rate of return of debt.

However, the financial advice in the OP is BADLY oversimplified and potentially dangerous. Equity and mortgage tax advantages are nice, but the sales pitch there is way too hard.

Renting vs. buying is very complicated. Equity is nice, but equity is MUCH more expensive than its sticker price. Comparing a mortgage payment to a rent check can make your eyes pop at the benefits of buying compared to renting. Then your roof breaks or a pipe bursts and you have to cover it yourself. And for some reason home owners insurance puts you back much further than renters insurance. Oh and property taxes - the list goes on.

Over very long periods of time buying can indeed be the superior choice, but it usually takes years, and a lot of the advantages are lost if you need or want to move - transaction costs put an enormous amount of financial friction into the calculations that eat away benefits you might otherwise have.

None of this is to say that renting is BETTER than buying, but buying isn't so obviously superior that it's an obvious investment to target.

This is a decent tool: http://www.nytimes.com/interactive/busi ... .html?_r=0


Thanks for this. A good rebuttal to the point, which I was hoping to get from this post, as I was sure his advice (though thought-provoking, was probably not right for everyone).

If my OP oversimplified, it's because I was simply trying to boil down his points to their simplest form. If I stepped too far, chalk that up to my own ignorance of this whole scheme.

It sounds to me like developing equity is occasionally a better alternative to the "pay loans as quickly as possible," if you're in the right circumstances; those circumstances require a good deal of analysis to determine. As usual there is probably no repayment system that is correct for everyone.

Cool. thanks for the info! The NYT tools is useful, also.

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thesealocust
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby thesealocust » Sat Apr 20, 2013 5:26 pm

Yep, seems about right. Buying can be a very interesting opportunity - some people leave law school with debt and a spouse and a kid and a town they know they'll be in forever, but some people leave law school with debt and a job in a new city.

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Mick Haller
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Mick Haller » Sat Apr 20, 2013 5:33 pm

You are only going to develop equity quickly if home values rise quickly. If you think that is going to happen, then by all means buy a house. Maybe you are correct.

My feeling is that there is way too much behind the scenes manipulation to predict anything with certainty in housing. Those who survived the mortgage meltdown are obviously waiting until values are back to 2005-2007 levels before putting their houses on the market. But will they find buyers? Unless lenders go back to making "NINA" loans, I don't expect many buyers. The 20-35 year old demographic (you know, the ones typically buying houses and starting families) will be discouraged from buying houses due to bad career prospects and student loan overhang.

This is a long term trend. I expect young families to be struggling for at least 10 more years. Hence no significant housing boom unless the same bad practices that caused the first crisis return.

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Mick Haller
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Mick Haller » Sat Apr 20, 2013 5:36 pm

thesealocust wrote:and a town they know they'll be in forever


This is another thing people don't always consider. If you don't stay in a house for at least 5 years, you tend to lose money. So it's not always wise to buy a house unless you plan to live there at least semi-permanently.

hds2388
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby hds2388 » Sat Apr 20, 2013 5:40 pm

Mick Haller wrote:
thesealocust wrote:and a town they know they'll be in forever


This is another thing people don't always consider. If you don't stay in a house for at least 5 years, you tend to lose money. So it's not always wise to buy a house unless you plan to live there at least semi-permanently.


Yeah, I mean, I know that buying a house isn't a good idea if you're planning on selling in less than 6 or so years.

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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby nordicsair » Sat Apr 20, 2013 5:44 pm

How about employer matching 401(k) accounts?

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Mick Haller
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Mick Haller » Sat Apr 20, 2013 5:58 pm

nordicsair wrote:How about employer matching 401(k) accounts?


go for it, but they usually only match up to like 3% of your paycheck.

hds2388
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby hds2388 » Sat Apr 20, 2013 6:03 pm

Mick Haller wrote:
nordicsair wrote:How about employer matching 401(k) accounts?


go for it, but they usually only match up to like 3% of your paycheck.



If at all. I know my firm doesn't match. :(

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thesealocust
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby thesealocust » Sat Apr 20, 2013 6:04 pm

Mick Haller wrote:
nordicsair wrote:How about employer matching 401(k) accounts?


go for it, but they usually only match up to like 3% of your paycheck.


The rate of return for a dollar invested and matched is over 100%. The rate of return for a dollar paying down an 8.5% loan is 8.5%.

100% is more than on order of magnitude larger than 8.5%.

Having said that, matched 401(k)s are extremely rare for law grads. Nearly no big law firms match, the government doesn't have 401(k)s, and I'd eat my hat if it were common amongst public interest organizations.

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Mick Haller
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Mick Haller » Sat Apr 20, 2013 6:12 pm

hds2388 wrote:

If at all. I know my firm doesn't match. :(


Nor does mine. Mine does not even offer 401k until you've been with the firm for 2+ years.

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Tiago Splitter
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Tiago Splitter » Sat Apr 20, 2013 10:06 pm

At some point you should start putting your emergency funds into a Roth IRA and/or make Roth deferrals to your 401k. Roth IRA contributions can be withdrawn tax and penalty free at any time, so if you have an emergency you can access those pretty quickly. 401k funds often can't be taken until you separate from service but after a while the only emergency that could require the draw down of all your assets is job loss. And if the big emergency never materializes, you'll have a shitload of Roth money built up rather than just taxable savings.

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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby paul554 » Sun Apr 21, 2013 9:59 am

thesealocust wrote:
Mick Haller wrote:
nordicsair wrote:How about employer matching 401(k) accounts?


go for it, but they usually only match up to like 3% of your paycheck.


The rate of return for a dollar invested and matched is over 100%. The rate of return for a dollar paying down an 8.5% loan is 8.5%.

100% is more than on order of magnitude larger than 8.5%.

Having said that, matched 401(k)s are extremely rare for law grads. Nearly no big law firms match, the government doesn't have 401(k)s, and I'd eat my hat if it were common amongst public interest organizations.


Actually the fed has the thrift savings plan (TSP). It is now available as a regular 401(k) or Roth. It matches 100% on the first 3% of your paycheck and 50% on the next 2%. When I worked for the Fed's a few years ago the number on people making ANY contribution was like 6% across the entire board so it is defiantly under utilized.

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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby M458 » Sun Apr 21, 2013 10:56 am

Tiago Splitter wrote:At some point you should start putting your emergency funds into a Roth IRA and/or make Roth deferrals to your 401k. Roth IRA contributions can be withdrawn tax and penalty free at any time, so if you have an emergency you can access those pretty quickly. 401k funds often can't be taken until you separate from service but after a while the only emergency that could require the draw down of all your assets is job loss. And if the big emergency never materializes, you'll have a shitload of Roth money built up rather than just taxable savings.


There's an income level at which you can't make Roth contributions anymore, isn't there? Does the typical Big Law salary ($145 - $160k) fall below or above tha threshold?

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Tiago Splitter
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Tiago Splitter » Sun Apr 21, 2013 11:05 am

M458 wrote:
Tiago Splitter wrote:At some point you should start putting your emergency funds into a Roth IRA and/or make Roth deferrals to your 401k. Roth IRA contributions can be withdrawn tax and penalty free at any time, so if you have an emergency you can access those pretty quickly. 401k funds often can't be taken until you separate from service but after a while the only emergency that could require the draw down of all your assets is job loss. And if the big emergency never materializes, you'll have a shitload of Roth money built up rather than just taxable savings.


There's an income level at which you can't make Roth contributions anymore, isn't there? Does the typical Big Law salary ($145 - $160k) fall below or above tha threshold?

You can contribute to a Traditional IRA and then immediately convert to a Roth. As long as you have no other pre-tax IRA assets it ends up being the equivalent of a Roth contribution.

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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby walkingpanda » Sun Apr 21, 2013 11:27 am

Yes, take that man's advice and then wait for Wells Fargo/BOA to come for your new house/condo because . . .well. . .

hds2388
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby hds2388 » Sun Apr 21, 2013 11:35 am

walkingpanda wrote:Yes, take that man's advice and then wait for Wells Fargo/BOA to come for your new house/condo because . . .well. . .


I mean... I guess I assumed people would realize I wouldn't advocate buying a house one couldn't afford, or would suggest taking on an inappropriate mortgage for a (probably 5th year) biglaw associate.

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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby Big Dog » Sun Apr 21, 2013 11:52 am

Gains the advantages of building equity...


Ask him how that would have worked out if you followed his advice in 2008..... :wink:

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TatteredDignity
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby TatteredDignity » Sun Apr 21, 2013 12:01 pm

hds2388 wrote:
Mick Haller wrote:
nordicsair wrote:How about employer matching 401(k) accounts?


go for it, but they usually only match up to like 3% of your paycheck.



If at all. I know my firm doesn't match. :(


This surprises me. My firm in a secondary market matches up to 6%, and I wouldn't think their benefits would be any better than the top NYC, etc. firms.

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IAFG
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Re: Is Paying Off Loans Fastest Always Best Idea?

Postby IAFG » Sun Apr 21, 2013 12:07 pm

TatteredDignity wrote:
This surprises me. My firm in a secondary market matches up to 6%, and I wouldn't think their benefits would be any better than the top NYC, etc. firms.

Bennies at top firms actually blow pretty hard. I think they realize young prospective associates don't look past the annual salary.




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