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Where to put excess money?
Old 11-07-2017, 08:15 AM   #1
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Where to put excess money?

My DD is a 30 year old, financially responsible, single, medical professional at the top of the 25% tax bracket (or just barely in the 28% tax bracket). She is currently contributing 6% to a 401K and has a $28,000 student loan at 3.25% interest and a $15,000 car loan at 3% interest.

In what order should she be applying excess cash?

1. Increasing 401K?
2. Paying off a student loan (highest interest rate)?
3. Paying off her car loan (smallest balance)?

or

1. Paying off her car loan (smallest balance)
2. Pay off a student loan - eliminate all debt
3. Increase 401K

( I think the above is what Dave Ramsey would recommend?)

or

Some other order?

Looking for recommendations on what makes the most financial sense as well as what makes the most psychological sense.
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Old 11-07-2017, 08:26 AM   #2
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She has a very high income for her age (good for her!). If I were she, I would max out that 401K. At her age, everything she puts in it has decades to grow! and she's lowering her taxes at the same time.

Conventional wisdom was always to pay off the highest-rate loan first; but with only a quarter-point difference on very low interest rate loans, I'd probably throw money at both of them every month.
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Old 11-07-2017, 08:31 AM   #3
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Fund a Roth IRA and put it into equities.... over the long run the tax-free growth will far exceed the interest paid on the car and student loans... and if she has some sort of emergency she can tap it to the extent of her contributions.

Otherwise, increase 401k contributions.
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Old 11-07-2017, 08:46 AM   #4
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I would pay off any loans first, and contribute to the 401k at a moderate rate. A loan is a warning sign that a person is not yet on his/her own. In addition, the market is high at this time. But I would contribute to 401k continuously, just not to impair the effort to pay off loans.
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Old 11-07-2017, 08:52 AM   #5
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I would pay off any loans first, and contribute to the 401k at a moderate rate. A loan is a warning sign that a person is not yet on his/her own. In addition, the market is high at this time. But I would contribute to 401k continuously, just not to impair the effort to pay off loans.
I agree. There's the hard math which at these low rates favors the investment assuming nominal returns.

Then there's the psychology of learning to deal with debt, and avoid it. Frankly, becoming debt free was what worked for us. I never wanted to go back.

I will say we continued to save and increase our 401k and investment rates while we paid off debt. In other words, the "excess money" went to both for a while.
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Old 11-07-2017, 09:09 AM   #6
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I'd probably use the 401k to stay under the 28% bracket and any other cliffs in the tax code. Absent any of those considerations, I would probably split the difference with incremental money used 50/50 to pay down loans faster/boost the 401k. If she does not have an ample emergency fund, I would build up at least 6 months of expenses first.
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Old 11-07-2017, 09:21 AM   #7
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I'm in the some other order camp. 1/3 to each
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Old 11-07-2017, 09:29 AM   #8
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I can't ever decide on just one way. So I split the difference and go a little in each possible direction.

Therefore, I would:

1) Continue to contribute up to the matching limit of the company's 401K.
2) Max out a ROTH IRA to minimize future RMD's, You'll thank yourself later. So many benefits later are currently income/asset tested. Start the 5 year waiting period. If needed, she can always dip into it for an emergency such as loss of job etc. Better to pay the 10% penalty than keep some $ aside earning a measly 1% in a savings account.
3)Pay off some of the school/car debt faster than required. While it may be better from a paper standpoint to invest that money where it earns higher interest, you never know what lies around the corner. If you loose your job for a while, or become disabled, having a lower/no loan balance is good.
4) Then add more to the 401K.
5) Keep a little bit out to enjoy life's pleasures.
6) Any future pay raises, assign 50% of that to paying off the loans. the other 50% increase the retirement savings plans.

If/when the market corrects, having the loans paid off would be better IMO than having one or two fixed loan payments.

You didn't mention if the company had a Roth 401K or not. I'm not sure where I'd be on a regular 401K vs a Roth 401k. maybe 50/50 in assets in pre-tax retirements
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Old 11-07-2017, 09:48 AM   #9
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... a $15,000 car loan ...
While you're helping her get this sorted out, try to convince her that borrowing money (or, worse, leasing) to get a car is financially foolish. If it's to get a current-model new car it is even more foolish.

Fun, maybe, but very expensive fun. Buy her an XBox or a nerf ball instead.
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Old 11-07-2017, 09:50 AM   #10
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.... A loan is a warning sign that a person is not yet on his/her own. ...
Malarkey. Many people have car loans... in fact, I do.... and I am on my own and have been for over 40 years. I also have a mortgage loan... by choice.

Ditto with a student loan... the OP's DD made an investment in her future by buying a good education and is reaping the rewards of that wise decision.

Our DD and DS are both on their own but have car loans.

Your thinking is way out of date.... there are good loans and bad loans... learn the difference.
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Old 11-07-2017, 09:57 AM   #11
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While you're helping her get this sorted out, try to convince her that borrowing money (or, worse, leasing) to get a car is financially foolish. If it's to get a current-model new car it is even more foolish.

Fun, maybe, but very expensive fun. Buy her an XBox or a nerf ball instead.
More marlarkey. I guess then that my 1.9% loan on my car is foolish? I have earned much more than that in the two years that I have had the loan expect to consistently beat 1.9%.... if not then a car loan will be the least of my worries.

DS and DD both have car loans of about the same as OP's DD and similar rates... in one case on a slightly used (1 year old) car and in the other case on a new car.... they are both enjoying having reliable, safe transportation with a manufacturer's warranty and I expect they will both keep their wheels for 5-10 years.
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Old 11-07-2017, 10:19 AM   #12
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.... there are good loans and bad loans... learn the difference.
Agreed. And I think I understand the difference:

"Good" loans are to make investments.
A house is an investment at least to the extent that its value rises with inflation, so leveraging to buy is likely to pay off. This assumes that the cost to own and maintain the home is somewhere near the economic value of its role as a place to live. I made a lot of money buying and renting residential property over 20+ years, always with borrowed money.

An education, assuming it is to gain a skill that employers are willing to pay for, is also clearly an investment with a payback.
"Bad" loans are used to buy depreciating assets or to buy things like vacation trips that are not assets at all.
A car loan is the poster child for a "bad" loan. For most, it involves buying a new car and taking a huge depreciation hit. Where a "bargain" rate is offered, the real cost is simply priced into the vehicle. TANSTAAFL. In some cases a new car loan may look attractive from an interest rate arbitrage standpoint, but IMO this is what Richard Thaler calls "framing" where the full scope of the decision is not considered. The scope not considered includes the first year depreciation hit, higher insurance costs, temptation to buy more car than is needed ("only $10/month more), etc. The interest rate arbitrage usually involves risk arbitrage as well, with the apparently better investment interest rate usually involving higher risk.
There may well be cases, though, where a home mortgage can be a "bad" loan and a car loan can be a "good" loan. The ones that come to my mind are where speculation is involved, buying a house in a hot market hoping for a greater fool, and buying a collector car at a good price in order to flip it. (Flipping collector cars is kind of fun, actually. I have flipped a couple of Shelby mustangs (GT350, GT500KR) and a Jensen Interceptor but I have never borrowed to do it.) For many undergraduate degrees, borrowing is a "bad" loan. ("Grande or Vente, sir?")

Obviously, YMMV.
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Old 11-07-2017, 10:29 AM   #13
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Too many loans can get a person to enjoy living above the means. I think for a person just started professional life, optimizing investment to the point of maximizing returns by loans, margins, or choosing hot stocks, should not be recommended. The person should have a good habit of LBYM and put more efforts on career.
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Old 11-07-2017, 10:29 AM   #14
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Agreed. And I think I understand the difference:

"Good" loans are to make investments.
A house is an investment at least to the extent that its value rises with inflation, so leveraging to buy is likely to pay off. This assumes that the cost to own and maintain the home is somewhere near the economic value of its role as a place to live. I made a lot of money buying and renting residential property over 20+ years, always with borrowed money.

An education, assuming it is to gain a skill that employers are willing to pay for, is also clearly an investment with a payback.
"Bad" loans are used to buy depreciating assets or to buy things like vacation trips that are not assets at all.
A car loan is the poster child for a "bad" loan. For most, it involves buying a new car and taking a huge depreciation hit. Where a "bargain" rate is offered, the real cost is simply priced into the vehicle. TANSTAAFL. In some cases a new car loan may look attractive from an interest rate arbitrage standpoint, but IMO this is what Richard Thaler calls "framing" where the full scope of the decision is not considered. The scope not considered includes the first year depreciation hit, higher insurance costs, temptation to buy more car than is needed ("only $10/month more), etc. The interest rate arbitrage usually involves risk arbitrage as well, with the apparently better investment interest rate usually involving higher risk.
There may well be cases, though, where a home mortgage can be a "bad" loan and a car loan can be a "good" loan. The ones that come to my mind are where speculation is involved, buying a house in a hot market hoping for a greater fool, and buying a collector car at a good price in order to flip it. (Flipping collector cars is kind of fun, actually. I have flipped a couple of Shelby mustangs (GT350, GT500KR) and a Jensen Interceptor but I have never borrowed to do it.) For many undergraduate degrees, borrowing is a "bad" loan. ("Grande or Vente, sir?")

Obviously, YMMV.

A loan is a loan and it should be evaluated in the context of one's overall balance sheet and financial picture rather than the specific purpose for which the debt is incurred. There was a time that I had 6 figures in credit card advances outstanding and only paid the minimum every month. Sound awful? These were 0%, 0 fee advances that I was able to roll over when they would have started incurring interest. When I did this I was making a healthy income, had a portfolio in the half million range, owned my own home with substantial equity, etc. As it happened, I used the proceeds of the CC debt to put money in a 5% savings account, but even in the context of my overall financial picture my debt level was reasonable and supportable.

Another example: suppose a lender offered you a zero fee, zero interest loan with a 100 year amortization schedule. Would this be "bad" debt? Personally, I would take every penny allowed.
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Old 11-07-2017, 10:38 AM   #15
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Another example: suppose a lender offered you a zero fee, zero interest loan with a 100 year amortization schedule. Would this be "bad" debt? Personally, I would take every penny allowed.
Yes, you can use the loan to buy a jet and enjoy your elevated life. But how could you pay it back?
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Old 11-07-2017, 10:51 AM   #16
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1. 401k...put in enough to get employer match

2. Max Roth ira

3. If there is enough money left over max 401k

4. Pay off car loan since its the smallest
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Old 11-07-2017, 10:53 AM   #17
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More marlarkey. I guess then that my 1.9% loan on my car is foolish? I have earned much more than that in the two years that I have had the loan expect to consistently beat 1.9%
Hindsight is 20/20. Its easy to say that now that the markets are on a massive bull run. Everyone is making money so that point is null. If the market would have tanked paying off that 1.9% would have looked mighty fine.
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Old 11-07-2017, 10:55 AM   #18
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I would do the 401K. But make sure it is invested in equities without MERs. The other loans are lifestyle expenses. I agree that the car loan is not a good expense. But it will teach her about good money and bad money.
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Old 11-07-2017, 10:58 AM   #19
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Hindsight is 20/20. Its easy to say that now that the markets are on a massive bull run. Everyone is making money so that point is null. If the market would have tanked paying off that 1.9% would have looked mighty fine.
Yep. Paid off my house in '99. Was told by a friend, that I was an idiot considering how investments would outrun the 5% loan.

I was not an idiot.

For many years, that was a great move. Today, doing the math, probably close to even and maybe even a little behind. It is a "don't care" if you will.

But man, I sleep at night just great.
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Old 11-07-2017, 11:09 AM   #20
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Dan32, you didn't mention how much money your DD has socked away in an emergency fund. Another thing to consider is how much of a monthly surplus your DD has today, on average, to replenish any temporary hit it would take if DD used some of it to pay off either or both loans.


That being said, I would suggest making sure DD is contributing up to any company match for the 401k. As for the loans, isn't student loan interest tax-deductible (under current law)? That would reduce the effective interest rate on that loan, probably below that of the car loan. So I would pay down the car loan before the student loan, but only after making sure the 401k match is assured and a 6-9 month EF is funded or can be easily and quickly replenished from current monthly surplus.
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