I've been a frequenter of r/personalfinance for years now, but never contributed any content of my own. So I was doing some personal budgeting as a result of COVID-19 and came across this decision. Essentially, it's the never-ending dilemma: "Do I invest or pay down debts?" Specifically, if my only debt is student loan debt, should I pay that down or invest?
TL;DR: It probably makes financial sense to pay down your student loan debt first even if your expected CAGR is higher by investing it. Theoretically, investing the money might yield a larger retirement balance, but it's likely negligible and not worth the sacrificed financial security of being debt free.
Before I dive into the math and assumptions, please feel free to comment and pick apart my "analysis". I mainly did this as a personal exercise, but then a friend suggested I post to reddit. I'm not a financial advisor in any capacity and this is not intended to represent any sort of financial advice. Do your own analysis :)
I always thought that the common advice given here in Reddit was wrong. The common advice I always see here is "contribute up to employer 401k match, then pay down your debts, then invest after you're debt free" and it's doled out almost indiscriminately. Then sometimes, I see somebody say it depends on the interest rate of your debt (read: student loans) and that if your interest rate is below a certain level (usually stated at <4%) you don't need to make accelerated payments. However, I never understood why it even mattered. Of course investing up to the employer match was obvious because it's a guaranteed ROI, but the rest I didn't agree with. My assumption was as follows:
Compounded interest on a loan is based on a factor of the interest rate multiplied by the loan principal. I always reasoned that as you pay down the loan, the interest also falls as well. However, when investing in retirement, your interest is always compounding in the opposite (positive) direction. So, I always thought to myself that even if your expected ROI for investments is 7% and your loan interest rate is 7%, you should still invest the money and make the minimum payments (10-year repayment plan) on your student loans. This is because the compounding interest on the retirement money has a 40-year horizon versus the compounding of loan interest is a maximum of 10-year horizon. This is obvious right? LOL WRONG
Over the weekend, I (thankfully) decided to check the math and calculate the actual numbers in Excel. To my surprise, I was wrong in my premise and I'm happy to admit how wrong I was; the interest rate on the loan definitely matters. In addition I'll take it one step further, unless your student loan interest rate is really low (read: < 3%) you probably should pay down your loans first anyways. This is just my opinion.
so here's the math: Available monthly money to use for debt payment or investing: $2,000 Student loan balance: $40,000 Student loan interest rate: 3.50% retirement horizon: 40 years, or 480 months (i.e. April 2060) Expected retirement interest rate: 7.00%
These numbers assume no changes over the 40-year period of the calculation. This is obviously wrong because there will almost certainly be inflation/deflation, COLA adjustments to salary, and etc. However, in order to forecast we need to project based on what we know now; so we leave numbers constant.
Three simulations showing a 10-year payoff term, 5-year payoff term, and 2-year payoff term:
in the most extreme case (2-year payoff term), after 40 years, you would have $73,903.20 LESS in retirement savings than had you invested more up front. This equates to $2,217.10/year LESS withdrawal rate (assuming 3.00% SWR). This further divides down to $184.76/month LESS.
So, in short (read: long), depending on the interest rate of the loan (and retirement fund growth), you could end up with more in retirement savings over the long run. However, it's likely negligible in and the financial security of having paid off the loans as quickly as you can afford might be worth the sacrifice of those lost gains.
I hope this helped anybody like myself that might have not done the calculations themselves. Please feel free to point out any errors in my assumptions or calculations.
In case anybody asks, the formulas used in Excel are: =CUMIPMT =PMT =FV
Submitted April 06, 2020 at 08:24PM by WannabePFS https://ift.tt/34dNNyz
