contribute to your 401k or pay off loans first?

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20130312
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Re: contribute to your 401k or pay off loans first?

Postby 20130312 » Mon Aug 20, 2012 10:10 am

Ah. In that case, I'd be a bit more wary. Obviously, low interest rates are to be expected for the next few years, considering how deep this recession was and also the Fed's commitment to keeping their benchmark at effectively 0% through 2014. Regardless, you want to get a variable interest rate loan paid off while it's still cheap (before it gets ridiculous, like 10%+).

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dingbat
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Re: contribute to your 401k or pay off loans first?

Postby dingbat » Mon Aug 20, 2012 10:55 am

InGoodFaith wrote:
Anonymous User wrote:My loans are at 2.99% (long story). I have approximately 200k in loans, but a big law job and a clerkship bonus this year. How much should I be paying towards my loans? I don't know much about IRAs and stuff like that (tho this thread has been very informative).


Is it a variable rate loan? If it's fixed at 3%, I wouldn't pay a dime more than I had to each month because your 401(k) (or IRA if you prefer) will CERTAINLY give you a rate of return better than 3% in the long run. But dingbat will give you a more technical analysis. Take it away ding!

I agree wholeheartedly (both with this and what was said later)
I'm also on school now so I'm a little short on time

Fark-o-vision
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Re: contribute to your 401k or pay off loans first?

Postby Fark-o-vision » Mon Aug 20, 2012 3:04 pm

I think what we're overlooking is that under a compound interest scenario your oldest money is the most valuable. when InGoodFaith mentioned that projecting out to thirty years changes the game, he wasn't really wrong. Just plugging in real quick to a calculator (which probably isn't a perfect representation) paying 11,200 dollars a year with an average return of 6.9% lands you with 1,240,200 dollars after 30 years. That doesn't take into account any match a firm might offer (I don't know if they do, but many employers do, regularly). So if your 10,000 401(k) investment becomes even a 13,000 dollar investment after match, it seems like you aren't doing yourself a disservice.

Also, correct me if I'm wrong (and I really accept that I probably am), but interest on a simple interest account only accrues on the principle portion, right?

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Re: contribute to your 401k or pay off loans first?

Postby 20130312 » Mon Aug 20, 2012 3:07 pm

Fark-o-vision wrote:Also, correct me if I'm wrong (and I really accept that I probably am), but interest on a simple interest account only accrues on the principle portion, right?


Principal*, but yes you are correct. Compound interest allows interest to accrue both on the principal and previously accrued interest.

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Re: contribute to your 401k or pay off loans first?

Postby Fark-o-vision » Mon Aug 20, 2012 3:10 pm

InGoodFaith wrote:
Fark-o-vision wrote:Also, correct me if I'm wrong (and I really accept that I probably am), but interest on a simple interest account only accrues on the principle portion, right?


Principal*, but yes you are correct. Compound interest allows interest to accrue both on the principal and previously accrued interest.


lol at self. Am I disqualified?

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Re: contribute to your 401k or pay off loans first?

Postby dingbat » Mon Aug 20, 2012 3:13 pm

Fark-o-vision wrote:I think what we're overlooking is that under a compound interest scenario your oldest money is the most valuable. when InGoodFaith mentioned that projecting out to thirty years changes the game, he wasn't really wrong. Just plugging in real quick to a calculator (which probably isn't a perfect representation) paying 11,200 dollars a year with an average return of 6.9% lands you with 1,240,200 dollars after 30 years. That doesn't take into account any match a firm might offer (I don't know if they do, but many employers do, regularly). So if your 10,000 401(k) investment becomes even a 13,000 dollar investment after match, it seems like you aren't doing yourself a disservice.

Also, correct me if I'm wrong (and I really accept that I probably am), but interest on a simple interest account only accrues on the principle portion, right?

The first part is an oversimplification. See my comment above.
Matching contributions should (almost) always be taken - That's an instant boost
Whether interest is simple or compounding does make a difference (a few basis points) but not a lot IRO the amortization (payback) period. It's easy to overestimate the impact, but it's really not that big.

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Re: contribute to your 401k or pay off loans first?

Postby Fark-o-vision » Mon Aug 20, 2012 3:21 pm

dingbat wrote:
Fark-o-vision wrote:I think what we're overlooking is that under a compound interest scenario your oldest money is the most valuable. when InGoodFaith mentioned that projecting out to thirty years changes the game, he wasn't really wrong. Just plugging in real quick to a calculator (which probably isn't a perfect representation) paying 11,200 dollars a year with an average return of 6.9% lands you with 1,240,200 dollars after 30 years. That doesn't take into account any match a firm might offer (I don't know if they do, but many employers do, regularly). So if your 10,000 401(k) investment becomes even a 13,000 dollar investment after match, it seems like you aren't doing yourself a disservice.

Also, correct me if I'm wrong (and I really accept that I probably am), but interest on a simple interest account only accrues on the principle portion, right?

The first part is an oversimplification. See my comment above.
Matching contributions should (almost) always be taken - That's an instant boost
Whether interest is simple or compounding does make a difference (a few basis points) but not a lot IRO the amortization (payback) period. It's easy to overestimate the impact, but it's really not that big.


I wasn't saying that it made a big deal during the pay off period of the student loan, I was saying that it makes a huge deal at the back end of the 401(k). contributing 10K for 20 years gives you a much different result than doing so for 30, which more than offsets the cost of carrying the student loan, or am I missing something?

I think part of the discussion that hasn't been addressed (at least not directly) is that it may make a difference based on how large your loan is, right?

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Re: contribute to your 401k or pay off loans first?

Postby CyLaw » Mon Aug 20, 2012 4:00 pm

For everyone that keeps saying that 401k is better because you get compound interest in an investment account whereas the student loan is simple interest, it does not work that way.

Once in repayment, it does not matter that the student loan interest is calculated using a simple interest model because you pay off the accrued interest each month with each payment (otherwise you would never pay any principal and never pay off the loan). Second, when you make extra payments on any loan towards the principal and you continue to make payments in the same amount as before, you get the same effects as compounding interest whether the loan is simple interest or compound interest. If you pay X towards pricinpal, then you will pay X * I less in interest for the next loan payment, where I is the interest rate adjusted for period between payments (normally the annual rate divided by 12 in case of student loans). If you keep the same monthly payment as before, then X*I of that payment which originally would have gone to interest will now go to principal. Because of that payment the following payment will not have to pay X*I*I in interest as well as the X*I from the first first payment to principal. This is the same effect as compounding interest.

The reasons you may want to invest in a 401k before paying off your loans may stem from a belief that the tax savings from the 401k may bring you out ahead or that the 401k space is use-it-or-lose-it. But it does not matter that the student loan interest is simple. That is the method used to calculate the interest you owe each payment, not the benefit you would get from paying down the loan.

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Re: contribute to your 401k or pay off loans first?

Postby Fark-o-vision » Mon Aug 20, 2012 4:04 pm

CyLaw wrote:For everyone that keeps saying that 401k is better because you get compound interest in an investment account whereas the student loan is simple interest, it does not work that way.

Once in repayment, it does not matter that the student loan interest is calculated using a simple interest model because you pay off the accrued interest each month with each payment (otherwise you would never pay any principal and never pay off the loan). Second, when you make extra payments on any loan towards the principal and you continue to make payments in the same amount as before, you get the same effects as compounding interest whether the loan is simple interest or compound interest. If you pay X towards pricinpal, then you will pay X * I less in interest for the next loan payment, where I is the interest rate adjusted for period between payments (normally the annual rate divided by 12 in case of student loans). If you keep the same monthly payment as before, then X*I of that payment which originally would have gone to interest will now go to principal. Because of that payment the following payment will not have to pay X*I*I in interest as well as the X*I from the first first payment to principal. This is the same effect as compounding interest.

The reasons you may want to invest in a 401k before paying off your loans may stem from a belief that the tax savings from the 401k may bring you out ahead or that the 401k space is use-it-or-lose-it. But it does not matter that the student loan interest is simple. That is the method used to calculate the interest you owe each payment, not the benefit you would get from paying down the loan.


But it also changes how fast the interest accrues, right? And it is possible, with IBR (although we clearly weren't talking about that) to pay less than the interest amount.

Edit: Another real reason to not rush your student loans, I think, is in case of emergency. Although you don't want to, you can always leave repayment if forced to. Very few other loans that I've heard of are as flexible as your student loan debt will be. Although they say six months, I've known people who have been in deferment (or whatever the other one is) for like two years because, at the end of the day, direct loans really, really does not want you to default.

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Re: contribute to your 401k or pay off loans first?

Postby CyLaw » Mon Aug 20, 2012 4:11 pm

dingbat wrote:
Fark-o-vision wrote: Difference of simple interest vs. compound interest still makes student loan the cheapest money you can get your hands on, usually (please don't rip with simple and obvious examples, like 0% car loan. It embarrasses all of us). meanwhile, the compounding factor of your 401(K) makes it a great long-term vehicle. Even if you want to play it safe and just keep pace with inflation, at least you have the money when you need it.

Maybe you think 6.8% is cheap. My current borrowing rate is significantly lower
If you think that the loan being simple means that it's better to leave that with a high balance and stick it into a 401k that compounds, it means you have no idea how loan amortization works.

Time for some simple math. Let's assume the 401(k) earns the same 6.8% (annualized rate) as the student loan.

Student Loan $100,000
10 years
Monthly Payment: $1,151 ($1,535 pretax)
Total payments: $138,096

Now, let's say you have $1,000 per month that you can either put into a 401(K) or use to pay down the loan. Let's assume a 25% tax rate

Option A) repay the loan
Monthly Payment$ 1,901
Time: 5 years, 3 months (2.65, but we'll round accordingly)
Total payments: $119,078
Savings: $19,018.
Now we put the full remaining balance into the 401K ($1,000 plus $1,535 pretax)
Balance at the end of 10 years: $171,210 (4 years and 9 months)

Option B) 401K
Monthly payment $1,000
Balance at the end of 10 years: $171,193

So, by putting it into the 401(k) you're more or less breaking even.
Except that while the interest rate on your student loan doesn't fluctuate, there are no guarantees on the investments in your 401(k)

If, like InGoodFaith, you can get returns in excess of 6.8%, you're better off.
If you can't, you're better off paying your loans off first.
Caveat: at least for the next few years, we can reasonably foresee a low interest rate environment. If you take risks (and invest well), you can get higher returns, but that is not typical.


Was trying to read through your example Dingbat and I had one comment. It appears that at the end of repayment for option A that you are paying $2,535 towards your 401k each year. If I read this right, then isn't this more than you would be allowed to contribute to a 401k in a year? I know the limit is $17k a year now and increases each year, but I doubt it would be $30,420 in time for your example to work. Depending on taxes, you might be able to shelter a post-tax amount equivalent to that pre-tax amount by using a Roth 401k, but then that needs to be included in the scenario.

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Re: contribute to your 401k or pay off loans first?

Postby CyLaw » Mon Aug 20, 2012 4:17 pm

Fark-o-vision wrote:
CyLaw wrote:For everyone that keeps saying that 401k is better because you get compound interest in an investment account whereas the student loan is simple interest, it does not work that way.

Once in repayment, it does not matter that the student loan interest is calculated using a simple interest model because you pay off the accrued interest each month with each payment (otherwise you would never pay any principal and never pay off the loan). Second, when you make extra payments on any loan towards the principal and you continue to make payments in the same amount as before, you get the same effects as compounding interest whether the loan is simple interest or compound interest. If you pay X towards pricinpal, then you will pay X * I less in interest for the next loan payment, where I is the interest rate adjusted for period between payments (normally the annual rate divided by 12 in case of student loans). If you keep the same monthly payment as before, then X*I of that payment which originally would have gone to interest will now go to principal. Because of that payment the following payment will not have to pay X*I*I in interest as well as the X*I from the first first payment to principal. This is the same effect as compounding interest.

The reasons you may want to invest in a 401k before paying off your loans may stem from a belief that the tax savings from the 401k may bring you out ahead or that the 401k space is use-it-or-lose-it. But it does not matter that the student loan interest is simple. That is the method used to calculate the interest you owe each payment, not the benefit you would get from paying down the loan.


But it also changes how fast the interest accrues, right? And it is possible, with IBR (although we clearly weren't talking about that) to pay less than the interest amount.

Edit: Another real reason to not rush your student loans, I think, is in case of emergency. Although you don't want to, you can always leave repayment if forced to. Very few other loans that I've heard of are as flexible as your student loan debt will be. Although they say six months, I've known people who have been in deferment (or whatever the other one is) for like two years because, at the end of the day, direct loans really, really does not want you to default.


In case of IBR, the excess interest is either forgiven for subsidized loans or capitalized into principal for unsubsidized loans, which would then start to rack up interest on itself even for simple interest loans.

For non-IBR, the only possible difference would be if the interest was calculated on a faster period than the payment period (daily vs monthly). Then yes there would be a tiny bit more interest in the compound case than the simple case. But if the interest is calculated at the same period as the payment, then it does not matter as the payment wipes out the accrued interest.

And your other reason is a legitimate one. While most people cite student loans as highly risky because they normally cannot be discharged in bk, they do have very generous repayment structures.

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Re: contribute to your 401k or pay off loans first?

Postby CyLaw » Mon Aug 20, 2012 4:26 pm

I should add that I personally plan to max out my 401k and my wife's TSP, and then put the remaining money towards student loans. With my wife's gov job I am less worried about needing access to money in case of a personal layoff. Also, my wife and I have little put aside right now towards retirement. While I am sure (because I ran the numbers) that paying off the loans would be better for us, the slight extra benefit each year by paying off the loan 6 months early (2.5 years repayment instead of 3 years repayment) is not worth my personal worrying about retirement. I would just feel better about saving for retirement then the slightly earlier loan payoff, especially given my wife's job and the flexible repayment plans with federal student loans.

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Re: contribute to your 401k or pay off loans first?

Postby Anonymous User » Sun Jun 29, 2014 10:48 pm

My big law employer doesn't match 401k. I have no loans and one year's worth of savings. Should I still invest in 401K? If so, should I max it out? My first priority is to pay for a downpayment and retirement.

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Re: contribute to your 401k or pay off loans first?

Postby Anonymous User » Sun Jun 29, 2014 11:17 pm

Now that you revived this thread... is it possible to pay back 60k in loans in one year on a NYC market salary+bonus?

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Re: contribute to your 401k or pay off loans first?

Postby brylemartin12 » Mon Sep 01, 2014 2:41 am

SPAM

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Re: contribute to your 401k or pay off loans first?

Postby ymmv » Mon Sep 01, 2014 9:30 am

Anonymous User wrote:Now that you revived this thread... is it possible to pay back 60k in loans in one year on a NYC market salary+bonus?


Sounds pretty rough. I mean if you're around, what, $100k take home? $110? Surviving in NY on $40k is a miserable proposition, if it's possible for a biglaw attorney at all. $50k sounds doable but would still be a little rough if you plan to live anywhere in reasonable distance of the office.

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Re: contribute to your 401k or pay off loans first?

Postby englawyer » Mon Sep 01, 2014 9:56 pm

ymmv wrote:
Anonymous User wrote:Now that you revived this thread... is it possible to pay back 60k in loans in one year on a NYC market salary+bonus?


Sounds pretty rough. I mean if you're around, what, $100k take home? $110? Surviving in NY on $40k is a miserable proposition, if it's possible for a biglaw attorney at all. $50k sounds doable but would still be a little rough if you plan to live anywhere in reasonable distance of the office.


Agree $50k is reasonably doable paying rent of under $2000/mo (about $7500 takehome per month after insurance etc = $2000 rent + $4000 loan + $1500 other). So either roommates in Manhattan or brooklyn/queens/nj. Unlikely to find a decent studio or 1BR in Manhattan at that price. Bonus will be about 6k after taxes so that will help too.




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