Paying off student loan aggressively versus maxing out 401k?

 

My friend M. asked me following question: "Initially we were going to pay off the student loans aggressively and be done in 12-14 months. Now we are considering maxing out both 401ks to get the tax benefit. What makes more sense?"
 
 
The question is about prioritizing. Prioritizing maxing out 401k versus paying off loans.
But there are few more things which are in the priority list.
Usually after finishing residency most physicians have following major items where a lot of money has to go:

Loans
Student loan
House mortgage
Car payments
Insurances
Term life insurance
Disability insurance
Car/home/liability insurance
Savings
Health savings account
Savings for retirement
 
 
How to prioritize them?
 
One way is to prioritize by risk/consequences.
 
Prioritizing by risk means to prioritize by the most detrimental impact which have to be taken care off first. For example, if the breadwinner of the family dies, his/hers income should be replaced in some way.
 
The insurances can be grouped together and should be taken care of first:
 
1. Disability - will cover lost income.
2. Term life - will pay out a certain sum of money to cover lost provider, is necessary is the loss of provider will be financially very hard on spouse and/or child.
3. Car/home/liability insurances - helps with large assets in the worst case scenario if they need to be replaced, liability gives additional protection in case of unintentional harm to others.
 
After you are done with that, you can move to the group of Savings and Paying off loans:

1. Health savings account - for current or future disease related expenses.
2. Savings for retirement 401k, Roth IRA - if prioritizing by risk, tax-deferred accounts should be put before paying off mortgage because there is a better protection for retirement accounts in case of a bankruptcy - you get to keep your pension and retirement plan funds. In Tennessee tax-exempt retirement accounts, including 401(k) are protected. Roth IRA is protected up to $1,283,025 as of 2018. (This amount is adjusted every three years. For detailed information for your state go to NOLO.com.)
3. Car payment, house mortgage and student loan - I would group them together especially if they have similar low interest rates. They are not as well protected as retirement accounts.
 
 
But what if you say: Yes, prioritizing by risk is all good, but I personally think that the bankruptcy risk is very low for me. Maybe it will be better for me to pay off the student loans or mortgage first, before maxing out 401k and Roth IRA?
 
 
I already wrote about the difference of paying off the mortgage early versus investing the money that was used for the extra principal payments. Investing comes out ahead.

With current interest rates, it makes more sense financially to invest instead of paying off the mortgage early. If your interest on student loan is in the same ball park as the current mortgage rates, that would have the same effect. And by investing in a tax-deferred account like 401k, you will also receive tax savings. 


How much tax savings can you get?
 
If you contribute maximum ($18,500 for 2018) to the pre-tax 401k, you will save $5,920 in 32% tax bracket and $6,475 in 35% bracket. This is a significant amount which can be put into Roth IRA ($5,500 in 2018, see my post on how to use the back-door Roth IRA).

In 2018 most physicians will be in the 32% or 35% bracket.
If both spouses are maxing out their 401k, the tax savings are doubling and will be $11,840 in 32% bracket and $12,950 in 35% bracket, which is enough for maxing out both Roth IRAs.
You will not get those tax savings if you choose to contribute to Roth-401k (see here why I don't do Roth401k).
 


If you are 45 years old now and will make yearly contributions of $18,500 to your 401k, then at the age of 65 with 6% yearly growth and 3% inflation the balance will be $700,949. The number is of course approximate because returns will vary.
 
If you decide to pay off your student loans first, you will have less years left to contribute before tax. Dependent on how many years you will have left to contribute, you will forgo on:

19 years left:
401k balance at age 65: $643,297
Difference in total savings balance at age 65: $57,652
Lost tax savings, 1 year: $5,920
 
18 years left:
401k balance at age 65: $588,907
Difference in total savings balance at age 65: $112,042
Lost tax savings, 2 years: $11,840


But that is not all.

The employers contributions were not taken in account yet.

How much employers contribute is variable. The total maximum on total contributions (employee plus employer) is $55,000 in 2018 (or 100% of your salary, whichever is less).
This means that your employer could contribute up to $36,500 in 2018. 


In summary, if you compare paying off a low interest loan like a mortgage or a low interest student loan, versus investing in a taxed account, you will come out ahead with investing.

If you compare paying off a loan versus contributing to a tax-advantaged account like pre-tax 401k, you will not only come out ahead with investing but also have your savings grow fax free, you will save on taxes and you will get employer's contributions.




 

Should I pay off the mortgage instead of investing?

 

Should I pay off the house instead of investing?
This is a question I received from a friend recently.
I am already done with paying off my mortgage. I did pay it off but at the same time I did invest too. I only made $1,500 additional principal payments per month.


There are many arguments out there supporting investing instead of paying additional principal to the mortgage. The main argument is that the investments will generate higher returns than paying off mortgage.



Investments will provide gains.
Paying off mortgage will reduce your debt.
What will be better at the end?


Below I will make calculations on my own example.


Mortgage on a $210,000 house

Down payment 20% equals $23,898
The financed amount is $186,102
Monthly payment: $867
The interest rate: 4.37%
The total interest to be paid to lender on a 30 years term: $148,301
Total interest paid in 8 years (paid down the mortgage in 8 years instead of 30): $33,659
Mortgage interest saved: $114,542

By paying off the house early I saved $114,542.

The total extra payments to the principal totaled to $135,000 for the period of 8 years.

The extra principal payments of $135,000 were not available for investing. If I would have invested that money gradually during those 8 years, then according to the bankrate calculator it would have produced $172,157 at the end of those 8 years assuming stable growth rate of 7% per year, 2.9% inflation, 36% federal tax and 0% state tax (for TN). Investing would have produced $37,157more in those 8 years.

Now after paying off the house in 8 years and saving 22 years of paying interest (total mortgage term of 30 years) I can invest the available $1,500 for the next 22 years. That would produce $665,212 with the same 7% returns. 

$665,121-$37,157=$627,964 that is after subtracting the $37,157 I had less by choosing to pay off the mortgage instead of investing for the first 8 years.
But I still paid mortgage interest for 8 years. Subtracting that interest of $33,659 leads to $594,305.


If I would have kept the mortgage for 30 years, and would have $1,500 available to invest from the beginning and until the end of the 30 years period, that would have produced $1,116,708. 
From that I have to subtract the total interest paid for 30 years - $148,301 and that equals to $968,407. 

If my calculations are correct, in 30 years, by paying off the house early and continuing investing $1,500 for the reminder of the mortgage term, I will have only $594,305 instead of $968,407. 
The difference of $374,102 is significant.
This money would have been available in year 2039 (in 21 years).
With the inflation of 2.9% per year that sum of money will equal $205,242 in todays dollars.  

Was it bad for me to pay off the mortgage early and forgo on $374,102 in 21 years?

That is the price I paid for the piece of mind.  I didn't know that, I only found it out today after calculating everything. It surprised me a little. Well, I hope that number will not matter that much when I get to the retirement. 

Those calculations are made for 4.37% mortgage interest. If your interest is lower, it will make even less sense to pay it off early.
All values are calculated with bankrate calculator assuming 7% yearly returns, 2.9% inflation, 36% federal tax and 0% state tax (for TN).


Now I will redo all calculations with more conservative 5% yearly return on investments.
Below is the same text but with different numbers.



The extra principal payments of $135,000 were not available for investing. If I would have invested that money gradually during those 8 years, then according to the bank rate calculator it would have produced $163,553 at the end of those 8 years assuming stable growth rate of 5% per year, 2.9% inflation, 36% federal tax and 0% state tax (for TN). Investing would have produced $28,553 more in those 8 years.
 
Now after paying off the house in 8 years and saving 22 years of paying interest (total mortgage term of 30 years) I can invest the available $1,500 for the next 22 years. That would produce $570,502 with the 5% returns. 
 
$570,502-$28,553=$541,949 that is after subtracting the $28,553 I had less by choosing to pay off the mortgage instead of investing for the first 8 years.
But I still paid mortgage interest for 8 years. Subtracting that interest of $33,659 leads to $508,290.
 
 
If I would have kept the mortgage for 30 years, and would have $1,500 available to invest from the beginning and until the end of the 30 years period, that would have produced $897,551. 
From that I have to subtract the total interest paid for 30 years - $148,301 and that equals to $749,250.   
If my calculations are correct, in 30 years, by paying off the house early and continuing investing $1,500 for the reminder of the mortgage term, I will have only $508,290  instead of $749,250. 
The difference of $240,960 is significant.
This money would have been available in year 2039 (in 21 years). With the inflation of 2.9% per year that sum of money will equal $132,197 in todays dollars.


There are many variables but it appears that you have to go below 3% of yearly returns on investments to break even (the difference at 3% of returns will still be $141,912 before inflation and $77,856 after inflation).



The common arguments supporting paying off the mortgage early are:

1. If you loose the job, you don't need to worry about the mortgage.
2. If you will have to move, you don't need to worry about two mortgages.
3. If you decide to retire early or have to stop working for some other reason, mortgage doesn't need to be covered by savings.
4. It is a way to diversify your investments.

I gather it is a form of diversification of assets and a sort of  insurance for the hard times. It turns out to be quite expensive. If you are thinking about paying off the mortgage early, make your own calculations.