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

EE's picture
Rank: Senior Baboon | 185

I've read several threads here on WSO about what one should do with their bonus. Some people say blow it all as a first year, you'll be swimming in it a few years down the road. Others have the more conservative approach of growing the 401k, one which I happen to agree with.

However, if someone, like myself, is about to graduate from college with a decent amount of student loan debt, does it make more sense to pay off the debt first and then start contributing to retirement?

I'm somewhat torn since annual retirement account returns have the potential to be larger than Prime lending rates, though they are of course quite variable and can be negative as well.

But then again, I've always been under the impression that one should eliminate personal debt as soon as possible, while still maintaining a reasonable standard of living, the definition of which can of course vary significantly based on whom you ask (such as some sociology major versus one of the uber-ballers here on WSO).

Thoughts?

Comments (49)

Mar 31, 2008

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********

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

Mar 31, 2008
atropolation:

Still, how many 22yr olds do you know who own a house?

none, props

------

"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."

------

"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."

Mar 31, 2008
atropolation:

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********

Marry me?

Either you sling crack rock or you got a wicked jump shot

Apr 1, 2008

If you get a 401K match, this is a no-brainer. Max your 401K. Think about it: You get $.5-$1.00 from your employer for every $1 you invest in your 401K. Conversely, that $1 only pays off $.70 (after taxes) of student debt.

Even if you get a 0% investment return, you're still better off keeping the debt and investing in the 401K.

$401-K aside, it's a matter of risk aversion. Personally, I'd be willing to take some risk and be pretty confidant that I can beat the 7% r(debt) in the market.

Mar 31, 2008

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

Learn More

Side-by-side comparison of top modeling training courses + exclusive discount through WSO here.

Mar 31, 2008

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?

Mar 31, 2008
tylderdurden:

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?

You don't pay taxes on contributions to your 401k. Assuming you have a ridiculously low rate on your student loans (I've seen 1.5-3.0%), I'd suggest deferring these loans as long as possible (e.g., up to 15 years).

Unless you're trying to buy a house in the very near future, I wouldn't worry about your credit rating - at your age, it's actually your lack of credit history that's weighing down your credit score (and only time will remedy this).

Mar 31, 2008

In my case, I have an almost 50/50 combo of private and gov't loans, the rates on the latter being quite low relative to the private which has been a floating Prime + 0 loan. I could defer public loans for some time I believe...

Interesting point, thanks.

smuguy97:
tylderdurden:

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?

You don't pay taxes on contributions to your 401k. Assuming you have a ridiculously low rate on your student loans (I've seen 1.5-3.0%), I'd suggest deferring these loans as long as possible (e.g., up to 15 years).

Unless you're trying to buy a house in the very near future, I wouldn't worry about your credit rating - at your age, it's actually your lack of credit history that's weighing down your credit score (and only time will remedy this).

------

"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."

------

"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."

Mar 31, 2008
  1. Being that it would be a 401k, my risk tolerance is low.
  2. I'm confident, but not confident enough where I'd be comfortable assuming I can generate a minimum 7% annualized return over 10 or so years, most hedge fund managers can't guarantee that.
tylderdurden:

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?

------

"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."

------

"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."

Mar 31, 2008
EE:

1. Being that it would be a 401k, my risk tolerance is low.
2. I'm confident, but not confident enough where I'd be comfortable assuming I can generate a minimum 7% annualized return over 10 or so years, most hedge fund managers can't guarantee that.

If you can't earn more than 7% annualized over 10 years, something is seriously wrong. Skip the mutual funds and just index. Do a search for the couch potato strategy. Modify for your country as needed of course.

http://www.canadianbusiness.com/my_money/investing...

Mar 31, 2008

Where can you get these 1.5-3.0% loans?

Mar 31, 2008
oasising:

Where can you get these 1.5-3.0% loans?

Federal student loans used to be priced at ridiculously low rates. Think this has since been rationalized though.

Mar 31, 2008

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

Mar 31, 2008

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.

Learn More

Side-by-side comparison of top modeling training courses + exclusive discount through WSO here.

Mar 31, 2008

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

Apr 3, 2008
Disjoint:

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

"so it's like arbitrage, but not". well, you got that part right at least. why not take out the loan in yen??!?!

the above is incredibly risky.

Mar 31, 2008

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.

Mar 31, 2008

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.

------

"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."

------

"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."

Apr 2, 2008

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.

Apr 2, 2008

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.

Apr 4, 2008

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.

Mar 31, 2008
pseudonymous1:

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)

well, it reduces the payments since your interest payments are a percentage of your outstanding principal. if i pay down my principal, the interest portion of my monthly payments will be lower.

------

"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."

------

"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."

May 14, 2013
EE:
pseudonymous1:

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)

well, it reduces the payments since your interest payments are a percentage of your outstanding principal. if i pay down my principal, the interest portion of my monthly payments will be lower.

------
"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."

Incorrect. Pseudonymous got it right though. The payments should stay the same, while the term decreases as payments chip away at more of the principal. This is some basic Intro to Finance stuff.

Apr 5, 2008

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.

Apr 5, 2008

that was intense and dreadfully thesis-like

May 14, 2013

My opinion; contribute all you can to the 401K and Roth. The interest you will pay on the student loans is negligible in the grand scheme. Although the 20K may end up costing you upwards of 25K upon completion of repayment, the cost of foregoing investing those funds in a qualified account is much, much greater. There are many tools you can find online to show you exactly what that could work out to be (of course will vary with time and ROI). Just remember: Present value of a dollar is always worth more than future value (pay yourself first).

May 14, 2013

Also how much are you making and how much do you owe on your loans and what's the interest? How much are you matched and at what rate

May 14, 2013

Max out and pay minimums forever

May 14, 2013

Not to be a debbie downer, but your retirement is the one thing creditors can't touch...that is unless your creditor is a vindictive bitch of a wife.

If the glove don't fit, you must acquit!

May 14, 2013

One thing to keep in mind is that paying down student debt is about as sure as a thing gets on risk-free returns. Especially at 6%. Student loans cannot be discharged in bankruptcy and 6% is a pretty good rate when the banks are offering 1-2% on deposits at best.

I recommend contributing just enough to get your employer match and devoting the remainder to paying off the student loans. You can worry about a Roth IRA next year; your student loan interest will not be deductible your first full year, so there are just as many tax advantages to paying down the student loan- the difference is that the student loan can offer you a basically guaranteed 6% that the Roth IRA probably can't.

Not to be a debbie downer, but your retirement is the one thing creditors can't touch...that is unless your creditor is a vindictive bitch of a wife.

Actually, while the SCOTUS ruled that your 401k/pretax IRA/pension is a spendthrift trust in most cases, you do not necessarily get the same BK protection for your Roth IRA- the cover you get for your Roth IRA boils down to your state.

After death and taxes, paying the piper on student loans is life's third guarantee to you. There is no way out of it besides maybe moving to Cuba. And you don't even get a tax deduction on it after your first (half) calendar year. Maybe you are foolish enough to believe you can get 5% Alpha in a Roth IRA. If you're wise, though, make debt repayment the priority besides getting the employer match.

    • 1
May 14, 2013

While I'm (hard-learned lesson) averse to consumer debt, the "no-brianer" theory of paying off debt unless you can match your interest rate with a ROI is flawed and does not factor in TVM. You're better off saving first and foremost, then paying debt minimum's second. You can always tap into the savings if you are up shit creek, but you get the compounded interest on the Roth/401(k).

Granted, student loans aren't "consumer" debt. Normal-leverage mortgages and student loans are "good" debts.

Save, save, save.

May 14, 2013
San Ford:

While I'm (hard-learned lesson) averse to consumer debt, the "no-brianer" theory of paying off debt unless you can match your interest rate with a ROI is flawed and does not factor in TVM. You're better off saving first and foremost, then paying debt minimum's second. You can always tap into the savings if you are up shit creek, but you get the compounded interest on the Roth/401(k).

You've got a good point with having a 1-2 months' emergency savings before aggressively paying down credit card debt, but don't forget that student lenders can even try to go after your Roth money in some cases. Also OP already has a job and is entitled to several months of UI if he gets laid off. This literally is debt that never goes away. Student loans are a modern form of debt peonage and if the question is Roth IRA vs. paying off student loans- not emergency savings vs. student loans or credit card debt, I would lean towards just paying the darned things off- short of investing up to the company match on your 401k contributions. You can always tap that if things turn pear-shaped, too.

May 14, 2013

i concur on illini's points. unelss you are at an uber high tax bracket to take advantage of it

May 14, 2013

First, if you really scored 20 grand in student loans at only 6% interest my congratulations. Federally Unsubsidized loans are about 6.8%. Even 0.8% over a 20 year student loan adds up. But over time your money grows faster when invested earlier (earlier) and its crucial to have your money work for you as early as possible. I agree with below, pay yourself first. If you cant make payments, just go back to school.

May 14, 2013

Thanks for all the comments guys. I think I am going to go with paying myself first.

@downtown768: My loans are at 6.55% and 5.35% and with the auto deduction they take off .25% then I have have two other loans at 3.8% and 5%. All those make up my $20K in student loan debt. So overall its actually a bit under 6% interest.

May 14, 2013

1/3 in savings account
1/3 Roth
1/3 student loan

If you lose your job, then you at least have money to pay those bills and loand payments out of savings for a period of time. My personal preference is to pay down debt though - it frees up your mind to think about making MORE money as opposed to having to think about the money you OWE.

Just my two sheckels

    • 1
May 14, 2013

nail the higher interest rates first... i agree with illini that you have unemployment insurance and shouldnt freak too much about losing your job but kill your loans down after getting your max match...

May 14, 2013

Shocked this hasn't been brought up, but you can't deduct student loan interest if you make over $75,000.

May 14, 2013

Yeah, good points by all. Always get the max-match on 401k; instant ROI (depending on vesting periods), even if your allocation is 100% money market funds...

May 14, 2013

Your retirement contributions are a capacity-limited, tax-advantaged channel, and your debt is not particularly egregious.

Pay the minimum on the student loans but prioritize contribution into retirement accounts next. Later in life you'll be able to pay off the loans if you wish, but you won't be able to plow more $$ into tax-advantaged accounts.

May 14, 2013

Thanks Nobama, thats interesting. I am about in the same boat as you. I am close to in the same boat as you. I am on track to be paid off in 4 years. I know all these people have been helpful, but I would definately do my best to get money into that Roth, and timing does matter when investing that money, especially when following index funds like with Vanguard. 401k is free money if your company matches a percentage--I max mine out. Debt still can be a pain and get it down to at least a level that you are comfortable with as quickly as possible. Or just eat lots of rice and beans.

Apr 6, 2008

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%.

May 14, 2013

20k private debt paydown, 10k govt debt and 5k into savings.

May 14, 2013

Agree, at the very least, knock out the private loans completely.

May 14, 2013
Comment