Help a Reader: Pay Off Loan or Roth IRA?

Here's an email I recently received from a reader:

I am 30 years old and gross about 70,000. My wife stays home with two young kids. We have a total of 48,000 in student loans left to be paid back over the next 8 years. We have an emergency fund of about 12,000.

I have delayed funding my 401K or a Roth IRA and have instead put that money (about 15,000) towards paying off one of the student loans that was at 8.5% over the last two years. I now have student loans of 18K at 6.8%, 20K at 4.5% and 10K at 2.5%. All are fixed rates. My employer pays an equivalent of 6% of my salary to a pension fund which is in an 80/20 stock/bond fund through Wells Fargo. (there is no choice in that other than the percent of stock/bonds)

The question is, with the current tax climate and stock market, would I be smarter to pay off the 18K at 6.8% loan (would take about 2-3 years) or fully fund a Roth IRA each of those years?

What's your advice for him?

Comments

[Investor Junkie]

You have your other ducks in a row.

Definitely pay off the 18k at 6.8% first. Pay the others others since they are at much lower rates and should be possible to beat when investing.

[jim]

If the 6% is all they've got going into retirement then I'd put more into retirement to get up to at least 10% of income. After that then pay off the student loans with the highest rate first. The loans aren't very high interest and that interest should be tax deductible as well.

[savvy]

I would suggest fully funding a traditional IRA for both the poster and his wife. In addition to boosting their retirement contributions, the contributions should be tax-deductible due to their AGI. Also, due to AGI, the student loan interest is probably deductible as well bringing the effective interest rate to only ~5.3%.

[Laura]

i would max out the student loans, but then i would also get a second job to max out the roths. that way you only have to earn $10k a year extra, which isn't much, so it's doable. and having a limit makes the extra work less onerous. i paid off my debt at the expense of the retirement accounts and wish i hadn't. You can't "catch up" on the retirement accounts.

[JimL]

Similar to what Laura said, get a second job. However, focus that money on debt elimination. Once the debt is paid off, quit the second job as you need to spend time with the family. Also, split the extra money between the Roth and adding more to the emergency account. Get emergency up to 9 months pay.

[cheapskate sandy]

Laura is spot on.

[Troy]

Pay off the debt. All of it.

Then invest. Forget the interest rates. Leverage is best used in business, not personal finances.

Much of the advice on saving for retirement is the theory of compuunding returns and "you can't get that time back"

True. But you also can't get that time back if you paid off the loans.

And all interest rates compound. Interest you earn, and interest you pay.

Keep this simple. Pay off the debt first. Then invest.

[BillV]

Second job or perhaps the wife could take a job after you get home, avoiding child care expenses.?

[Marie]

As a SAHM myself, don't put your wife through a second job unless you need it to eat. Your kids will only be young once and that time is stuff you can never get back period.

I say a hybrid strategy.
Get a Roth on one of you and max it out. Then put the rest to the loan. Although if 12k isn't 3 months expenses I would do that first.

[GH]

I am the original poster. I would really like to thank everyone for the advice. Now what to do....haha!

I really hate debt and I will likely focus all extra money to paying off the 6.8% loan first. I will consider a second job and alternative methods of earning money. However, I really do hate to miss out on three years of compounding interest. Hmmmm...it's just a hard decision.

Thanks again everyone.

[StackingCash]

Again, don't be fooled by the financial industry telling you how much you will miss out if you don't invest NOW! How about maxing out your student loans, credit cards, and HELOC and go invest...er gamble...

Troy said it correctly earlier..."And all interest rates compound. Interest you earn, and interest you pay."

Pay off your debts and you will "feel" better, which is priceless.

[MSC]

I like the hybrid approach. Save 6% of your salary in your 401k to get the company match. That's a 100% return on your investment! Pay off the highest student loans first, the 6.5%, then the 4.5%. The last loan is at less than inflation at 2.5%, so the opportunity cost of ivesting the amount in your 401k is better. If you can start a Roth IRA by cutting personal expenses, I would try doing that. Don't worry about maxing it out. Your principal amount in a Roth is after-tax, so you can look at it as part of your emergency fund since withdrawals of principal are not taxable. Roth plus emergency fund makes up to $17,000 in year! A second job is a good idea, but don't sacrifice quality time with your family at your young age. That will make you feel a lot better than worrying whether you'll have $3 million at retirement versus $3.5 million.

[WAG]

I was your age 39 years ago. A wise old friend and business associate told me to save 10% of whatever I made and invest it. Great advice then and great advice now. Retired now with no money cares and enjoying each day to the max. Good luck.

[Jeremy]

The OP is similar to our position. My wife and I have about 120K in student debt at an average of 5%. We're both relatively young (30 and 26), rent is cheap, and have no other debt. We gross about 110K a year combined, though I make considerably more than she does (and brought considerably more student debt into the relationship.) We have been paying about twice the min. on the student debt, investing 10% in retirement, and saving as much as we can for a downpayment. Now that we are sitting on a pile of cash for dp, we looking at it and thinking that a house might not be the right option, and that it might be better to pay down the huge debt down or invest the dp in a long term taxable position and just keep doing what we are doing. When we have kids, my hope is that she can stay home too, so I can appreciate how challenging these decisions are for the OP.

[Travis]

Given that the reader has their needs covered and extra to contribute to debt/retirement a second job is not needed. The time would be better spent with his family and young children.

I suggest a hybrid approach as well. No one says you have to max a ROTH for both you and your wife. You can split this by maxing one ROTH and paying down the debt. Alternatively, if you get a match for 401(k) contributions I would suggest contributing to the 401(k) to get the match and then direct the extra to the student loan debt.

[Squirrelers]

I would focus on paying off the student loans, and boosting your emergency funds. Taking a holistic approach to viewing this situation, I think the peace of mind that you will have knowing that you're debt free and having a cushion protecting you in case of emergency will be priceless. Take that stress off your backs, and protect your family.

[kitty]

I wouldn't rush low interest loans - 2.5% and maybe even 4.5%. The interest rates cannot go down any more. If we get higher interest rates next year, 2.5% may be easy to beat even with straight CDs. So I'd put saving/investment over 2.5% loans. I would pay 6.8% loan first, but keep paying minimum on the others and see what happens with the interest rates and inflation.

[Troy]

The thing about scenarios like this is to examine the question from different angles.

Investing in a Roth assumes an increase in the value of the investment. While likely, that is not guaranteed. Paying down a student loan assumes a decrease in the balance. That is both likely and guaranteed.

If you "knew" the Roth would decrease in value, would your position change. There is a chance it will.

You even stated in your comments about "missing out on three years of compuonding interest"

Trust me, you are not missing out on anything. Your DEBT's interest is compounding. Don't just focus on compounding assets, focue on compounding liabilities. And if the value of your Roth decreases, guess what compunds...Your losses.

Interest rates affect money identically whether it is owned or owed. The interest rate doesn't know or care. Asset or liability it doesn't matter.

By taking advantage of the "compounding" of an investment, you are allowing the "compounding" of your debt. You are delaying the repayment, which effectively negates the benefit of investing in the first place. $100 in assets and $100 in liabilites is the same as $100K in assets and $100K in liabilities. You are still broke with a zero net worth. But your liabilities returns are fixed. Your assets are not.

[jim]

I really don't see any need for a 2nd job. Having student loans at 2-6% interest is not any kind of desperate situation where he has to spend all his free time away from his family for years. They take in $70k a year. He was able to put $15k over 2 years towards a loan so he's got $7500 / year to put towards debt. Sounds like they're doing just fine to me.

[Budgeting in the Fun Stuff]

My husband and I make about $78k jointly and have a $10k car loan and a $73k mortgage.

We contribute the minimum to my 401k to get the maximum company match (6%), fund one Roth IRA, and put $2500 a year into individual high dividend stocks through Scottrade (our bridge fund between early retirement at 52 and "normal" retirement age).

After that, we're paying down the car loan with all the extra right now. Since early retirement is our most important goal, that's what we concentrate on.

Figure out what you and your wife want out of life and contribute to that...we don't have kids, so I'm just assuming but debt freedom probably reduces stress a ton if you don't have that hanging over your head with child expenses as well...prioritize based on your situation. :-)

[MSC]

I agree with @Budgeting..

Debt and leverage are a part of our capital system. If you had an inheritance, paying cash outright for your next house might be a good thing, but for most young couples just out of college, with kids, student loans, child care, and the basic costs of living, a mortgage is necessary. A fixed-rate 30-year loan at a low interest rate can cost next to nothing when inflation and tax benefits are counted towards your total cost of shelter. As inflation rises around 3.5% per year, your earnings rise, your payment stays the same, and hopefully your house keeps pace. Later on in the mortgage, your monthly payment will look like a car payment, and the extra cash can be used to invest for retirement, or just to enjoy life.

Investing for retirement is a LONG-term proposition. You can't look at 5-year, 10-year, or even 20-year time spans on ROI, and say that investing in a Roth is better than paying down low-interest debt. You are 30 years old and may not retire until 40 years later, at which time you will continue to invest in your Roth or Brokerage for another 10-20 years beyond 70. A 10% return every year is probably not realistic, but if you can manage 6-8% over 40 years, it really is worth looking at the cost of NOT investing long term, versus paying down short-term, low-interest debt.

[Bad_Brad]

I'm a bit amazed at those who have advised a second job. My wife stays at home with 2 (soon to be 3) kids right now. We have only my income. At one point, before we had kids, we had two incomes. I am not sure we were better off financially, as we had an additional car with gas/insurance/maintenance, we ate out a lot more often, and we were in a higher income tax bracket. And I know we were worse off from a quality of life standpoint, as we consistently spent our weekends doing laundry, cleaning, and everything else that my wife now can do during the weekdays when I'm at work. Today, with the kids, we would also be looking at a pretty large daycare bill - as would the original poster here as he has two kids. Net/net, your wife would have to have a pretty decent income just to break even financially. I suppose it is a personal decision, but so many people think it is a personal finance panacea to have two incomes when in fact, in many cases, it is far from it.

/rant

On the question of whether to pay down debt or invest, I would say if your company matches your 401(k) contribution, you would be foolish not to contribute at least that much. Beyond that, it is also a personal decision. If I was in your shoes, I would try to max out the Roth IRA and try to refinance the higher rate student loans into a single loan with a lower rate. Of course, it also kind of depends on your overall cash flow situation. If you have enough money to do both (max the Roth IRA and pay some extra on the highest rate loan), by all means do it.

[StackingCash]

"A 10% return every year is probably not realistic, but if you can manage 6-8% over 40 years..."

What happens if it's NEGATIVE 6 to 8 percent? I love it when people try to downplay the risks to investing. I love it even more when they bring the rate of inflation into the advice. I don't want to sound so negative but I do want everyone to understand the risks. Investing is gambling. Realize you CAN lose money in the stock market.

[MSC]

@StackingCash: I'd advise staying out of stocks, mutual funds, 401ks, Roth IRAs, etc. Put your cash in a Mason jar and bury it out in your back yard. As long as no one sees you, it should be much safer than risking it in the real world. I'd also get started on building that bomb shelter in case Iran gets nukes.

There is no SAFE investment. What if the cash you have stocked away in a jar suddenly loses most of its value to inflation caused by our growing national debt? Same thing can happen with the price of gold if the dollar shoots upward. Don't tell anyone you have all that cash or valuables or they might get stolen.

What are talking about inflation? All I pointed out is that a fixed mortgage payment gradually decreases in financial impact on your budget due to inflation of both your earnings and the value of real estate.