To Pay Off or To Save?
Posted on September 22, 2005 6 Comments
Every time my student loan bill arrives, I wince at the balance. Even though I’m following my personal payment schedule, even though I’m reaching my goals towards paying down the debt – it still pains me to see the total. It’s my ball and chain.
I day dream with glazed-over eyes about the day I have no more student loans to pay… I can save more! I can get a car! I can take vacations! I can get a nicer apartment! But until then, it’s $200 per month, every month, for what feels like the rest of my life.
I fantasize about taking all my savings and paying off my loans, just to get it over with. I’d be free, free from this monthly commitment. Paying off all the partying, hangovers, time wasted on old boyfriends and of course, college classes, is no small feat. I just want it to be done! That way I could save more each month, right???
Well, no. Turns out that paying off your student loan debt slowly while parting leftovers between a 401K and savings account is a good way to go. Check out this article from Kiplingers:
Save or Pay Down Debt?
Get rid of high-interest debt before you start setting aside cash.
By Cameron Huddleston February 24, 2003
Should you be putting money in savings or investments at the same time you’re paying off a loan?
That’s one of the most frequently asked questions we get at Kiplinger, and the answer isn’t always obvious. Even if you have run up a balance on a high-rate credit card, you may hear a nagging voice in your head urging you to keep plowing money into savings for retirement, college for the kids or a new home.
The simplistic solution — to invest if you can earn a higher interest rate than you’re paying on your loans — can be downright dangerous. That became clear when, in the late ’90s, a wave of questionable advice suggested that homeowners actually create more debt to invest in the booming stock market — by pulling out some equity via a cash-out refinancing or home-equity loan. Then came the bear market.
The best answer lies in separating good debt from bad debt. It’s almost always a good idea to get rid of credit card and other high-interest loans before you start setting aside cash. However, you probably don’t want to accelerate mortgage or student loans at the expense of saving for retirement.
Begin by making a list of all your debt and the interest rates on those debts to prioritize which ones you should pay first, says Deena Katz, president of Coral Gables, Fla., financial planners Evensky, Brown and Katz. Then look at your alternatives for saving and investing and, if necessary, reset your priorities.
Step 1: Pay off the high-interest debt
If you have high-interest credit card debt, tackle that first. It doesn’t make sense to start saving or investing until you’ve paid off this debt. You’d have to make more than 20% after-tax return on stocks, bonds or mutual funds to make them a better investment than paying off a credit card with an interest rate above 15%, says Clark Randall, a financial planner with Lincoln Financial Advisors in Dallas.
There is one exception to that rule of thumb: If your employer offers a 401(k) plan and will match your contributions up to a certain level, fund it up to that level — even if you have credit card debt — because you’re getting a 100% return on your investment, says Randall. Contribute more than the match level once you’ve paid off your consumer debt.
If you’re drowning in debt, liquidate assets such as stocks and use your savings — but not a 401(k) or IRA — to pay off your credit cards. If you’re in dire straits, you can borrow up to 50% (no more than $50,000) from a 401(k). Although you pay yourself back with interest, you give up tax-free compounding, and you will have to pay back the loan immediately if you leave your employer.
Step 2: Identify the good debt
For the most part, it’s usually not a good idea to pay off your home mortgage unless you have a lot of extra cash. After all, Uncle Sam refunds part of your interest payment if you itemize your deductions on your tax return.
Use your money instead to invest in liquid assets. However, Randall recommends paying off your mortgage (and any other debt you might have) by the time you retire so you can get by on less money.
Don’t be in a rush to pay off student loans, either. The old rule that allows a tax deduction only for interest paid during the first five years of repayment is ending. Starting in 2002, qualifying interest on student loans can be written off no matter how long it takes to pay off your loans.
However, you can ease the burden of repaying your loans. If you have more than one student loan from the federal government, you might be able to receive an interest rate reduction if you consolidate your loans. You can also lower your monthly payments this way, leaving you with more money to pay off consumer debt.
If you elect to have your loan payments automatically deducted from your bank account, you can get a 0.25% interest rate reduction on your student loans. The Education Department’s Direct Loan Program has more about repayment incentives.
Step 3: Save and invest
Once you’ve eliminated high-interest consumer debt, start saving as much as you can. The best place to begin is a 401(k). The next best option is an IRA (see “Open Your First IRA”).
In addition to putting money into a retirement account, you need cash that’s readily available in an emergency so you don’t have to rely on credit cards. (If you are paying down your credit card balances and still paying high rates, it is probably better to keep paying off the cards and borrow from them in case of an emergency, says Katz.)
Set aside enough money to tide you over for three months if your paycheck suddenly stopped. If you have less-than-steady income, such as from a commissioned sales position, or a job that has more exposure to economic fluctuations, consider setting aside six months’ income.
Sock it away in a high-yield account such as a money market fund on a monthly basis until you reach your desired amount.
Category: Old Posts
Comments
6 Responses to “To Pay Off or To Save?”
Leave a Reply
September 22nd, 2005 @ 8:07 pm
That article is right, it’s always contribute to your IRA and 401K as much as you can and then tackle the debt. At least that’s what Suze Orman says on her show. Fortunately, I don’t have student loans and my money goes to my 401K and make IRA contributions when I can to make sure it maxes out by the end of the year.
Nicole…I think the first two comments are spam comments. =)
Terry
September 22nd, 2005 @ 11:00 pm
I agree with tershania. the first two are clearly BLOG SPAMMERS!
That said, thank you for posting this article nicole! I was just thinking about whether to put more into my student loan or start diversifying my investments when a little bit of my income is freed up next month.
One thing kiplinger forgot to mention about student loan interest deduction: It’s deductible only up to a point. The current phase-out income level starts at $50K, and over $65K doesn’t get a tax cookie at all. With or without the deduction, the terms on my student loan are favorable enough that I think I’ll focus on other things before rushing to pay it off.
September 25th, 2005 @ 10:02 pm
Deleting the spam….
October 4th, 2005 @ 5:35 am
i think i read somewhere that unless you’re company offers a matching contribution, you’re better off putting your money in a self-directed IRA and a Roth IRA.
October 25th, 2005 @ 2:37 am
whats the interest rate you’re paying in your student loans?
if its higher than 6% i’d suggest paying it off first.
the reason is because of what i read in 2 books
1. bull! by maggie mahar
2. yes, you can time the market by ben stein.
both of them claim that the average investor only makes 6% on average per year over a 20 years period and that the much hyped 11% return in stocks is a myth.
that being said, i have no debt other than my mortgages[which makes me over $1million in debt]. I also rent my own home. my goal for 2006 is to double my debt !
October 26th, 2005 @ 3:35 am
Oh I’m paying like a 3% interest rate on my student loans. It’s very cheap. More annoying than anything.