Poll: Pay off debt or Invest in retirement account

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Debt or Investment

Pay off debt--it's a guaranteed, risk-free 6.8% investment
21
27%
401k--If your firm matches, don't leave money on the table
29
38%
Some combination of the two
25
32%
Other (Roth IRAs, indexes, etc.)
2
3%
 
Total votes: 77

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thesealocust
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Re: Poll: Pay off debt or Invest in retirement account

Postby thesealocust » Sun Feb 17, 2013 5:07 pm

albusdumbledore: Let's just leave aside your example. As dingbat pointed out and as I tried to show with ~math~ it was apples and oranges, and not at all useful to continue considering.

The fundamental point, which isn't actually debatable, is that a 6.8% guaranteed interest rate on loans you pay down should be considered against your investment alternatives.

So what are your alternatives? A Roth IRA is one, with a very nice tax advantage. But your rate of return is (a) uncertain and (b) crudely inversely related to your risk.

Spoiler alert: Even long-term bonds (subject to tremendous interest rate risk and, if not treasuries, credit risk) aren't yielding 5% right now. I think vanguard's long term treasury fund is at like 2.5% yield and has an average duration of 15 years, making it tremendously risky in a rising interest rate environment.

You could dump all of your cash into small cap companies, call options on the dow, leveraged structured products, and gold coins in a Roth IRA. Then hope that it yields more than 6.8% (or as dingbat points out, more than ~4.9% due to the tax advantage?) - and you may well be right that your choice wound up being more valuable than paying down loans.

But it's a big risk. A 6.8% risk free rate of return is a gang-buster return on your investment right now, and that's exactly what paying down loans is.

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 5:09 pm

thesealocust wrote:You could dump all of your cash into small cap companies, call options on the dow, leveraged structured products, and gold coins in a Roth IRA. Then hope that it yields more than 6.8% (or as dingbat points out, more than ~4.9% due to the tax advantage?) - and you may well be right that your choice wound up being more valuable than paying down loans.

But it's a big risk. A 6.8% risk free rate of return is a gang-buster return on your investment right now, and that's exactly what paying down loans is.
I have issues with that conversion as well, but I'm too lazy to go into detail about it

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albusdumbledore
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Re: Poll: Pay off debt or Invest in retirement account

Postby albusdumbledore » Sun Feb 17, 2013 5:29 pm

dingbat wrote:
albusdumbledore wrote:You're a special kind of dense bro. There are three options with Option 1's extra 40k after paying the loans:

1. Blow it.
2. Save it as cash.
3. Save it in a taxable account at an assumed similar investment rate.

I didn't avoid any anything--I just assumed one was most likely. Option 2 wins with any of them at age 65. Which goes to show that it's a lot more complicated than the overly-simplistic "ONLY DO IT IF YOU CAN BEAT YOUR LOAN INTEREST RATE". I chose 5% deliberately because it is less than 6.8%.

I can make a comment about assumptions, but suffice to say that you were running an apples to oranges comparison. Even if it's more likely that a person blows it, that doesn't make it a reasonable comparison.
I'll not comment on option 2, which I'm sure we can both agree will give a much worse return.

Now, if you care to tell me what your assumptions are for #3, I'll be happy to discuss those, but, barring that, I'll again direct you to this post, which shows that, with respect to prepaying a loan or sticking the money into a 401k both options are similar. We can argue the merits of a 401k vs traditional IRA vs Roth IRA, if you wish.

As an aside, if you're arguing about a tax-advantaged investment vs a non-tax advantaged investment, then 6.8% is roughly equivalent to 4.9% (assuming 28% tax rate), which is a fair point, but doesn't address the issue


I told you what my assumptions were for #3. A 5% investment return at 20% capital gains rate. So here's what happens for each of the three options:

1. Blow it. Example stands.

Option 1 Balance at 65: 467k. Option 2 Balance at 65: 654k.

2. Save it as cash.

Option 1 Balance at 65: 510k. Option 2 Balance at 65: 654k.

3. Save it in a taxable account at an assumed similar investment rate.

So assuming 5% (we assumed this in the Roth) and 20% long term capital gains rate (this is less than actual capital gains rate now). 43k @ effective rate of 4% for 34 years of compounding comes to:

Option 1 Balance at 65: 630k. Option 2 Balance at 65: 654k.

So there's your math sealocust. The fact that I assumed #1 doesn't matter. It just changes the degree to which I was correct.

All of this simply to show that it isn't a simple comparison of interest rates. The tax advantages of a Roth are great and you're boning yourself if you aren't using it. Also if you can't pull 5% investing, you're a genuinely terrible investor.

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 5:38 pm

^ please explain again what your payment structures are

Specifically, how much per month are you putting toward Roth + Loans total, and what are the two proposed splits (how much to Roth and how much to loan) until the loan is fully repaid, and what the assumed savings thereafter are, so I can run the numbers

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albusdumbledore
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Re: Poll: Pay off debt or Invest in retirement account

Postby albusdumbledore » Sun Feb 17, 2013 5:57 pm

dingbat wrote:^ please explain again what your payment structures are

Specifically, how much per month are you putting toward Roth + Loans total, and what are the two proposed splits (how much to Roth and how much to loan) until the loan is fully repaid, and what the assumed savings thereafter are, so I can run the numbers

All in my original post. 40k yearly toward Roth + Loan, assuming you max out the Roth @5500 contribution yearly, assumed savings thereafter is the same for both outside of the 43k or so that Option 1 has earlier than Option 2 due to finishing loans early. Honestly, if you can find where I'm wrong I'd actually like to know, or we can take this to PM's so we don't further destroy this thread.

keg411
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Re: Poll: Pay off debt or Invest in retirement account

Postby keg411 » Sun Feb 17, 2013 6:11 pm

This goes back a couple of pages, but CD's currently have shitty-ass interest rates. Mine is at like 0.8% or something (and it might actually be even lower than that). In 2005, when I started the thing, it was at over 5.25%, but that was back in 2006. Which is why I'm looking for an alternate "emergency fund" option (I'm going to talk to an actual financial advisor about this stuff in August-ish to see if that's the right play or if putting it towards my loans is better).

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 6:17 pm

albusdumbledore wrote:
dingbat wrote:^ please explain again what your payment structures are

Specifically, how much per month are you putting toward Roth + Loans total, and what are the two proposed splits (how much to Roth and how much to loan) until the loan is fully repaid, and what the assumed savings thereafter are, so I can run the numbers

All in my original post. 40k yearly toward Roth + Loan, assuming you max out the Roth @5500 contribution yearly, assumed savings thereafter is the same for both outside of the 43k or so that Option 1 has earlier than Option 2 due to finishing loans early. Honestly, if you can find where I'm wrong I'd actually like to know, or we can take this to PM's so we don't further destroy this thread.

I'm pretty sure we already destroyed the thread.

I've made the following assumptions: Total loans: $200k; interest rate: 7.5% ($60k at 6.8% and 140k at 7.8%), total annual contribution to loans and/or savings: $40k/yr; rate of return on investment: 5% pretax, 4% post-tax (in the Roth vs outside the Roth); period: 40 years

If you start by maxing out the Roth, at $5,500 per year, and contribute the remainder to loans, $34,500 per year, until it's paid off, thereafter investing it in a similar manner, but without the tax advantages of the Roth, then after 40 years the total will be $2,879,314

If you start out by maxing the loan repayment, at $40,000 per year, and $0 toward the Roth, until the loan is paid off, thereafter maxing the Roth contributions and sticking the rest in similar investments, but without the tax advantage, then after 40 years the total will be $2,832,736, which is approximately 1.6% lower

Note that this is a back of the hand type calculation, omitting a large number of factors, but, based on the above, yes, you're correct, by taking on that risk, you end up 1.6% better off
(note that if you assume a shorter time frame, the difference becomes smaller)

edit: happy to send you the model I just built.

09042014
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Re: Poll: Pay off debt or Invest in retirement account

Postby 09042014 » Sun Feb 17, 2013 6:30 pm

Federal student loans do compound. It's only on IBR they don't, correct?

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 6:34 pm

Desert Fox wrote:Federal student loans do compound. It's only on IBR they don't, correct?


Capitalized Interest

The interest that accrues on loan(s), if not paid prior to a specific date, is added to the principal balance. For your education loan(s), this occurs at the end of a deferment, forbearance or grace period on Unsubsidized Loans, and at the end of a forbearance period on a Subsidized Loan.
Note: If you are repaying under the Income-Based Repayment (IBR) Plan and have a partial financial hardship when a deferment or forbearance ends, accrued interest (1) will capitalize only after your partial financial hardship ends or you leave the IBR Plan and (2) will not capitalize after your deferment and/or forbearance ends.
Capitalization results in an increased principal balance amount. You will accrue future interest based on the higher principal balance. When you receive a loan through the Direct Loan Program, you are required to pay interest on the money borrowed. The interest is generally considered the cost of borrowing money. Interest accrues daily on your outstanding principal balance.

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thesealocust
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Re: Poll: Pay off debt or Invest in retirement account

Postby thesealocust » Sun Feb 17, 2013 6:39 pm

A good takeaway is that IRAs (or 401(k) contributions, even unmatched) aren't insane compared to 6.8% loans, especially on a biglaw salary and able to make aggressive loan repayment and as retirement investment.

09042014
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Re: Poll: Pay off debt or Invest in retirement account

Postby 09042014 » Sun Feb 17, 2013 6:43 pm

dingbat wrote:
Desert Fox wrote:Federal student loans do compound. It's only on IBR they don't, correct?


Capitalized Interest

The interest that accrues on loan(s), if not paid prior to a specific date, is added to the principal balance. For your education loan(s), this occurs at the end of a deferment, forbearance or grace period on Unsubsidized Loans, and at the end of a forbearance period on a Subsidized Loan.
Note: If you are repaying under the Income-Based Repayment (IBR) Plan and have a partial financial hardship when a deferment or forbearance ends, accrued interest (1) will capitalize only after your partial financial hardship ends or you leave the IBR Plan and (2) will not capitalize after your deferment and/or forbearance ends.
Capitalization results in an increased principal balance amount. You will accrue future interest based on the higher principal balance. When you receive a loan through the Direct Loan Program, you are required to pay interest on the money borrowed. The interest is generally considered the cost of borrowing money. Interest accrues daily on your outstanding principal balance.


Pardon my ignorance, but how is that different than compounding interest after you enter the repayment period?

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Tiago Splitter
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Re: Poll: Pay off debt or Invest in retirement account

Postby Tiago Splitter » Sun Feb 17, 2013 6:45 pm

thesealocust wrote:A good takeaway is that IRAs (or 401(k) contributions, even unmatched) aren't insane compared to 6.8% loans, especially on a biglaw salary and able to make aggressive loan repayment and as retirement investment.

And since everyone agrees that an emergency fund is a good idea you can use a Roth for part of your emergency fund and if you don't have any emergencies you get the best of both worlds.

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 6:49 pm

Desert Fox wrote:
dingbat wrote:
Desert Fox wrote:Federal student loans do compound. It's only on IBR they don't, correct?


Capitalized Interest

The interest that accrues on loan(s), if not paid prior to a specific date, is added to the principal balance. For your education loan(s), this occurs at the end of a deferment, forbearance or grace period on Unsubsidized Loans, and at the end of a forbearance period on a Subsidized Loan.
Note: If you are repaying under the Income-Based Repayment (IBR) Plan and have a partial financial hardship when a deferment or forbearance ends, accrued interest (1) will capitalize only after your partial financial hardship ends or you leave the IBR Plan and (2) will not capitalize after your deferment and/or forbearance ends.
Capitalization results in an increased principal balance amount. You will accrue future interest based on the higher principal balance. When you receive a loan through the Direct Loan Program, you are required to pay interest on the money borrowed. The interest is generally considered the cost of borrowing money. Interest accrues daily on your outstanding principal balance.


Pardon my ignorance, but how is that different than compounding interest after you enter the repayment period?

practically, no difference - they compound (technically a declining balance doesn't compound, but that's semantics).

Note the limitation re IBR and financial hardship.

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 6:50 pm

Tiago Splitter wrote:
thesealocust wrote:A good takeaway is that IRAs (or 401(k) contributions, even unmatched) aren't insane compared to 6.8% loans, especially on a biglaw salary and able to make aggressive loan repayment and as retirement investment.

And since everyone agrees that an emergency fund is a good idea you can use a Roth for part of your emergency fund and if you don't have any emergencies you get the best of both worlds.

considering the 10% withdrawal penalty, that's debatable, but not unadvisable

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albusdumbledore
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Re: Poll: Pay off debt or Invest in retirement account

Postby albusdumbledore » Sun Feb 17, 2013 6:55 pm

dingbat wrote:
Tiago Splitter wrote:
thesealocust wrote:A good takeaway is that IRAs (or 401(k) contributions, even unmatched) aren't insane compared to 6.8% loans, especially on a biglaw salary and able to make aggressive loan repayment and as retirement investment.

And since everyone agrees that an emergency fund is a good idea you can use a Roth for part of your emergency fund and if you don't have any emergencies you get the best of both worlds.

considering the 10% withdrawal penalty, that's debatable, but not unadvisable

The 10% penalty is only on earnings. You can pull out your contributions at any time penalty-free even if you aren't 59 and a half, but I'm pretty sure you can't put them back. Which is a bad thing so generally still not advisable.

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thesealocust
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Re: Poll: Pay off debt or Invest in retirement account

Postby thesealocust » Sun Feb 17, 2013 6:59 pm

dingbat wrote:
Tiago Splitter wrote:
thesealocust wrote:A good takeaway is that IRAs (or 401(k) contributions, even unmatched) aren't insane compared to 6.8% loans, especially on a biglaw salary and able to make aggressive loan repayment and as retirement investment.

And since everyone agrees that an emergency fund is a good idea you can use a Roth for part of your emergency fund and if you don't have any emergencies you get the best of both worlds.

considering the 10% withdrawal penalty, that's debatable, but not unadvisable


One important point is that the money you add to a roth isn't locked in until the next tax year... I think. So if you put $5,500 in on January 1, as long as you take it OUT before you file the following february, I'm pretty sure it's treated (for tax purposes) like it was never in a Roth (so you're taxed in gain/loss as normal).

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 7:02 pm

albusdumbledore wrote:
dingbat wrote:
Tiago Splitter wrote:
thesealocust wrote:A good takeaway is that IRAs (or 401(k) contributions, even unmatched) aren't insane compared to 6.8% loans, especially on a biglaw salary and able to make aggressive loan repayment and as retirement investment.

And since everyone agrees that an emergency fund is a good idea you can use a Roth for part of your emergency fund and if you don't have any emergencies you get the best of both worlds.

considering the 10% withdrawal penalty, that's debatable, but not unadvisable

The 10% penalty is only on earnings. You can pull out your contributions at any time penalty-free even if you aren't 59 and a half, but I'm pretty sure you can't put them back. Which is a bad thing so generally still not advisable.

I just looked it up, and you're right, withdrawals are presumed to be from contributions first, and those are not taxed (Roth conversions have taxable withdrawals coming out before tax free withdrawals, for anyone considering going that route)

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Tiago Splitter
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Re: Poll: Pay off debt or Invest in retirement account

Postby Tiago Splitter » Sun Feb 17, 2013 7:07 pm

No penalty on withdrawals of contributions. Presumably, most of the money you get into the Roth in the first few years will be principal so that's why the Roth acts as something of an emergency fund with upside. As for putting the money back, you get one 60 day rollover in any 12 month period, so if you need the money for an emergency you get 60 days to put back in whatever you can, but then you can't start another rollover for a full year.

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albusdumbledore
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Re: Poll: Pay off debt or Invest in retirement account

Postby albusdumbledore » Sun Feb 17, 2013 7:12 pm

Tiago Splitter wrote:No penalty on withdrawals of contributions. Presumably, most of the money you get into the Roth in the first few years will be principal so that's why the Roth acts as something of an emergency fund with upside. As for putting the money back, you get one 60 day rollover in any 12 month period, so if you need the money for an emergency you get 60 days to put back in whatever you can, but then you can't start another rollover for a full year.

Good to know. It's a pretty good strategy really, especially once you've got enough in there so that earnings are greater than contributions and anything you pulled out would be relatively inconsequential.

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fatduck
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Re: Poll: Pay off debt or Invest in retirement account

Postby fatduck » Sun Feb 17, 2013 7:18 pm

Desert Fox wrote:Pardon my ignorance, but how is that different than compounding interest after you enter the repayment period?

that was my question which sparked these five pages of argument. i'm still not sure what the answer is.

09042014
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Re: Poll: Pay off debt or Invest in retirement account

Postby 09042014 » Sun Feb 17, 2013 7:25 pm

fatduck wrote:
Desert Fox wrote:Pardon my ignorance, but how is that different than compounding interest after you enter the repayment period?

that was my question which sparked these five pages of argument. i'm still not sure what the answer is.


It seems that it's not if you paying it back. But if you are in IBR it won't capitalize if you don't pay it. But on Big Law, IBR will force you to pay your interest anyway.

But if someone is making like 45K, they might be better off not paying any more than IBR asks for since, their interest isn't capitalizing.

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albusdumbledore
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Re: Poll: Pay off debt or Invest in retirement account

Postby albusdumbledore » Sun Feb 17, 2013 7:37 pm

Desert Fox wrote:
fatduck wrote:
Desert Fox wrote:Pardon my ignorance, but how is that different than compounding interest after you enter the repayment period?

that was my question which sparked these five pages of argument. i'm still not sure what the answer is.


It seems that it's not if you paying it back. But if you are in IBR it won't capitalize if you don't pay it. But on Big Law, IBR will force you to pay your interest anyway.

But if someone is making like 45K, they might be better off not paying any more than IBR asks for since, their interest isn't capitalizing.

Federal loans capitalize (read: compound) until you enter repayment. At which point, they're simple interest, so you won't accrue interest on interest, just interest on the principle.

What IBR does is allow your minimum payment to drop below the interest payment, which means you aren't actually eating into principle. But the loans are still simple interest, so you still will only ever be charged interest on the original principle amount, despite the fact that you're underpaying. And then 20 some years later you get bombed with a giant tax bill after they forgive whatever is left that you owe.

09042014
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Re: Poll: Pay off debt or Invest in retirement account

Postby 09042014 » Sun Feb 17, 2013 7:56 pm

albusdumbledore wrote:
Desert Fox wrote:
fatduck wrote:
Desert Fox wrote:Pardon my ignorance, but how is that different than compounding interest after you enter the repayment period?

that was my question which sparked these five pages of argument. i'm still not sure what the answer is.


It seems that it's not if you paying it back. But if you are in IBR it won't capitalize if you don't pay it. But on Big Law, IBR will force you to pay your interest anyway.

But if someone is making like 45K, they might be better off not paying any more than IBR asks for since, their interest isn't capitalizing.

Federal loans capitalize (read: compound) until you enter repayment. At which point, they're simple interest, so you won't accrue interest on interest, just interest on the principle.

What IBR does is allow your minimum payment to drop below the interest payment, which means you aren't actually eating into principle. But the loans are still simple interest, so you still will only ever be charged interest on the original principle amount, despite the fact that you're underpaying. And then 20 some years later you get bombed with a giant tax bill after they forgive whatever is left that you owe.


Do you have a source for saying that it changes to simple interest upon entering repayment?

Edit: NM I see what you mean after reading Dingbats post.
Last edited by 09042014 on Sun Feb 17, 2013 8:01 pm, edited 1 time in total.

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dingbat
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Re: Poll: Pay off debt or Invest in retirement account

Postby dingbat » Sun Feb 17, 2013 8:00 pm

albusdumbledore wrote:Federal loans capitalize (read: compound) until you enter repayment. At which point, they're simple interest, so you won't accrue interest on interest, just interest on the principle.

I don't want to derail, and for all practical purposes this information is fine, but technically, on a declining balance loan (e.g. vanilla mortgage or student loan) there's never interest on interest. However, that doesn't mean it's simple interest (it isn't - student loan interest is calculated daily)

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albusdumbledore
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Re: Poll: Pay off debt or Invest in retirement account

Postby albusdumbledore » Sun Feb 17, 2013 8:08 pm

dingbat wrote:
albusdumbledore wrote:Federal loans capitalize (read: compound) until you enter repayment. At which point, they're simple interest, so you won't accrue interest on interest, just interest on the principle.

I don't want to derail, and for all practical purposes this information is fine, but technically, on a declining balance loan (e.g. vanilla mortgage or student loan) there's never interest on interest. However, that doesn't mean it's simple interest (it isn't - student loan interest is calculated daily)

Yeah fair enough. It's not credit card interest though.




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