Bonus Use: Pay Off Student Loans vs. Grow the 401k

I received a somewhat large inheritance my final year of college. I ended up using it for my student loans and for a house (that I also inherited.....:/) Paying off my student loans definitely helped improve my credit rating though, which qualified me for my mortgage....before the whole mess was made. Still, how many 22yr olds do you know who own a house? I do not regret any decision I made regarding it.

********"Babies don't cost money, they MAKE money." - Jerri Blank********

I would pay off the loans first. Better to look towards the future without a cloud of debt from the past hanging over your head

It's a pretty simple decision. If you invested the money, can you earn a higher return after taxes than the interest you pay on the student loan. Paying off the student loan at say.. (and I'm going to pull numbers out of my ass).. 5% is like a getting a risk-free return of 7% before taxes (or whatever the tax rate is).

1) What is your risk tolerance? 2) How confident are you in picking funds/stocks/etc?

Where can you get these 1.5-3.0% loans?

Max out your 401K for the year or at least put in enough to max out your company's match and then work on paying off the debt

I think Tylerdurden nailed it (great SN by the way, a kid on my desk was just checking out those audrina pics that are up)...

Ideally you would invest your money in a way that would earn you a return greater than the IR on your debt. You should probably diversify and allocate some money to your 401-k (for the tax/retirement benefits), pay off some debt, splurge a little, and throw the rest in your PA (trading account).

Also, don't forget that different types of debt are regarded differently by creditors/lenders. Obviously, mortgage debt and student loan debt are better than credit credit debt. You can have student loans (I do), a condo mortgage (I do), multiple credit cards (I do) and still have a 750+ credit score (I do).

P.S. Not sure why one deserves props or marriage proposals for inheriting money and a house. Well maybe the marriage proposals from gold-digging slurs but inheriting a house at 22 is cool but it is in no way worthy of merit or praise.

Never pay off debt, debt is like free money! Put it off for the longest time possible. I am getting a 7% on my gov debt and 8% on my private loans (getting kicked in the testies really hard), and yet, I'd rather pay my interests slowly (tax deductible) and I believe I can invest the money at more than 8% considering my business school education; I hope that I can make 10% instead of 8% so it's like arbitrage, but not. What I am also hoping is to take out a loan in Euros, at a much lower rate (4%) reimburse my US loan. And then hope that the pound sterling appreciates like CRAZY in the near future vs. the Euro so that I can smoothly repay my Euro loan. I am playing the FOREX with loans because I am young and willing to lose a LOT.

Remember, you will always be a salesman, no matter how fancy your title is. - My ex girlfriend

What did I do? I blew my bonus. I don't even remember on what exactly, but I didn't save it, that's for sure.

What do I wish I would have done? Having the benefit of hindsight, I should have paid down the student loan debt.

You're young. You have so much time to make money. You'll make enough money to sufficiently invest and max out on your 401K, invest in the stock market and build up your savings. Not having student loan debt hanging over your head translates to freedom to perhaps make career or life choices later that perhaps you're not considering right now.

You could compromise too. Paid off the bulk of your student loan debt and stash a bit into savings.

And JoeMontana, I totally forgot about employer matching, thanks!

As of now I think my plan will be as follows:

I'll max out my employer contribution to my 401k. I'll use the rest to pay off as much private student loan debt as I can. The federal loans I'll hold off on as long as possible and then just make minimal payments for a while.

This is still pretty tentative as this entire discussion is relatively premature for me since I start work in May and who knows what stub, if any, I'll receive for this calendar year.

Big thanks to everyone that added their input, I got a variety of answers which was what I had hoped for originally.

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"its the running joke now, we now have fair trade with china so they send us poisoned sea food and we send them fraudulent securities."

First off, like some of you here, I had a large ($100K) amount of student debt when I graduated. I should not have had that much, but I made a series of mistakes and, oh well, live and learn (with a lot less money).

I used a good portion of my first year bonus to pay off debt, simply because it was at an 8% interest rate and because I owed around $1,000+ per month on it.

(again this is a really long story and I don't want to bore you with the details, but I imagine most people would not be in as bad a situation as I was)

I still saved a good portion of my salary/bonus and have reduced my debt to much more manageable levels. And I have enough saved/invested to be comfortable even with all the firings/cuts going on.

I would not think about your student loans in terms of interest rates there vs. returns in the stock market or anything. Instead, I would think in terms of monthly payments. If they are exorbitantly high, as mine were, it's best to pay off some of the debt.

But if you only owe $50-100 a month or something, I wouldn't bother... maybe if you somehow had a super-high interest rate on a low amount of debt that would be worth paying off, but I don't see how that could happen.

Also, some of you have mentioned that student loan payments are tax-deductible. Not quite the case, for 2 reasons:

1) Only student loan INTEREST is tax-deductible. 2) Only deductible up to $60K annual salary... aka, can't do it from your 2nd year onward in banking.

Regardless of what you decide to do, I would highly recommend NOT blowing your bonus. Yes, you're young and yes, it's not that huge a deal, but you want to get into the habit of SAVING early on. Sure, go out and buy a nice toy with it, but don't spend $50,000 on a new car... that is a total waste IMO.

That's just my take on things. Personally I hate having debt simply because of the large amount of monthly cash flow I lose. And yes, theoretically I can get a higher return from the market IF I have a really long time horizon, but in a given year if I have a ridiculous amount of monthly payments, I really don't care if 40 years down the road, I'll have earned an 11% average return vs. 7% by paying off the debt... I just want to stop the bloodshed.

Great advice dosk. Without taking the time to check everyone's profiles, I have a strong suspicion that most of the people arguing return rates vs. interest rates are college students who have no idea what it's like to have to pay bills every month. In the real world, cash flow dictates lifestyle—on a monthly or even daily basis—and the percentages matter a lot less than the actual number of dollars going in or out of your pocket each month.

Liquidity risk is something I think more and more about with regard to my student loans. Assuming that (because you have student loans in the first place), you and your family aren't all that wealthy, is it really worth it to blow all of your cash (liquidity) to pay down debt so early on?

I know that I was gung-ho about paying down my debt ASAP. That is, of course, until i actually had the capability of doing so. Then I realized that it was a bit naive, financially speaking, to dump all my cash into paying off debt.

Say you've saved up $50k...why waste it on your loans? The point of financial leverage is to provide freedom now, at the cost of interest payments later on.

I see it as a form of self-insurance, against any and all catastrophe, to hold on to lots of liquid cash while you're young.

What happens if I get laid off the day after I pay-off my loans? I'm fucked.

What happens if my brother needs some surgery that isn't going to be covered by insurance the day after I pay off my loans? He's fucked.

Besides, it's not like paying down my loans reduces my monthly payments--it simply alters the amount of principal i'm paying each month and therefore reduces the term. (other peoples' loans may work differently, but i can't speak to that)

The point is, there are highly practical benefits to having cash on hand, above and beyond exploiting arbitrage opportunities that arise from cheap debt.

You guys all make a lot of money--save it for a few years, pay the few extra grand (if that) in interest, and enjoy the freedom that the cash affords you today.

Quick summary: my plan is to 1) build a cash cushion, 2) save 10% of my base in my 401k, 3) pay off student loans ASAP, and after goals 1-3 are met, I will 4) roll everything else into investments and my 401k.

I'm surprised liquidity wasn't mentioned until so late in this tread. Good insights pseudonymous1. Also, if you indexed over the last nine years, you lost money. See the WSJ for more. It was on the front page of the WSJ within the last two weeks. So if you think that by indexing, you could have out-earned the 7% int rate on student loans, you would by down more than 7% today (again, over the last nine years).

I intend to do a combination of things through my first full year of banking. First, my employer doesn't offer a 401k match, so there is no "minimum" amount I should contribute to receive any additional economic benefit. Tax benefits are tax benefits, whether I contribute $16k or 0 (unless, of course, by contributing $16k, I could be knocked down a tax bracket). For 2008, the 28% tax bracket is $78,850 - $164,550. Since I will only be work for half of the year - since it's my first year - I will likely be in the 25% tax bracket ($32,500 - $78,850). I will work at a MM in NY, and at my firm, half-yr bonuses are given to first-year analysts at calendar year end. Assuming a base of $60k and a full-year bonus of $60k, my first calendar year base will be about $30k and bonus $30k. Of course, my bonus could be $10, $20, or higher/lower. Who knows. So, my first calendar yr total comp will be about $60k. Even if I commit all $16k to my 401k, it won't be enough to knock me down a tax bracket. The same goes for my first full calendar year of banking. With total comp somewhere between $100k and $150k, I'm still in the middle of the 28% tax bracket...no 401k contributions will move me into a different tax bracket, not for the first six months, not for my first full calendar year.

Dosk, great point about student loan int only being deductible at income less than $60k. If I have a good bonus, I will also be excluded from those tax deductions. Even if I get total comp around $55k, I will have other income from other jobs above $5k (from my last yr of undergrad), which also may push me above the threshold. I don't have near the loan amounts some people talk about (mine total less than $25k). With that said, I have a lot of suit shopping ahead of me, and at my firm, no signing bonus was given. That will come via cash & credit cards.

To answer the question of the OP, here is my personal plan:

-I am fairly risk averse - in a large part - due to my student loans. Right now, I don't think I could ever be an entrepreneur. I enjoy having a steady stream of cash coming in the door via my IB job. Maybe that will change as my financial picture changes, but for now, I'm risk averse. -Stay liquid! It seems to me that a lot of first year analysts who post on this board think they will always be in IB or some other high-paying job. Yeah right. Everyone thinks they can handle the stress and the hours. Fact: not everyone can. Turnover is extremely high. I plan to keep a fair amount of cash on hand. Nothing too specific. Enough for about six to nine months of living expenses (including rent, food, transportation, insurance payments, student loan payments, a little extra for additional transportation for job interviews, etc). I also may want enough on hand to take a two week trip to the Caribbean.
-Cash is my first priority. After I have my desired cash cushion established, then I'll put 10% of my base toward 401k contributions (about $6k/yr). -Next, I'll pay off my student loans ASAP. My int rate is around 6.8% for most of my loans. Assuming a good bonus, I could potentially pay off all my student loans with my first half-calendar year bonus and fund my cash cushion through base salary savings.
-Anything left over will be saved and rolled into investments. Only after I pay off my student loans will I contribute more than 10% of my base. I doubt I will purchase a condo within my first two-three years. Who knows how long I'll be living in NY. If I live in NY for anything less than two years, the closing fees may wipe out any capital appreciation on the condo.

Phew.

F9 -- Judging from your post I don't think you understand tax brackets. These are marginal rates. Entering into a new bracket does not mean your entire income is now taxed at the next level. As a result, the tax benefit from putting money into a 401(k) is least beneficial when it crosses over into a low bracket. I'd rather get a tax shield on dollars taxed at 40% than dollars taxed at 28%.