We’re speaking about personal finances, not Apple who have enormous loans and also enormous funds offshore.
If you have a loan you pay for it, if you pay it more quickly then you pay less interest. Going by the numbers, you can ease your payments on a CC by switching to a lower interest CC, but you’re still paying interest on it. Pay off the debt more quickly and the interest you pay is reduced.
But the idea is that the amount by which the interest is reduced (in terms of actual dollars paid over the life of the loan) might be smaller than the amount (in terms of actual dollars) of interest gained had you invested the money in some other way.
A simplified example: If I have a $1000 loan at 10% interest, due in one year, then we could describe my situation as me having a $1000 asset, and a $1100 liability, for a net value of -$100.
If I pay it off on day zero, then (pretending no other money things happen over the course of the year) I now have, at the end of the year, $0 in assets and $0 in liabilities. From -$100 to $0, is a net gain of $100.
But if I instead invest that $1000 into something that earns 20%, then after a year, I have a $1200 asset, and a $1100 liability, for a net value of $100–that’s a net gain of $200.
Investing was better than paying off the loan in that case, as investing allowed you to gain more money than the interest that would have been reduced by paying off the loan.
Buy my daughter a plane ticket to come home for spring break.
We asked our financial adviser a similar question this morning for our daughter, who is damn frugal. She and her husband will have lots of money to put away. He said that if you plan on using it within 3 years, a safe if low paying investment is best. If you don’t plan on using it, a riskier investment is best. They are going to be buying a house within 3 years, so we didn’t ask about investment vehicles for her.
I know nothing about investment.
What is an index fund, and what do I need to know/do?
It doesn’t matter. The principal is identical.
No investment you make will outperform paying off a credit card, because credit card interest rates are gigantic. But that’s not what we’re talking about. Frylock said he oes not have any credit card debt.
So what’s better? An investment that pays you 3.5%, per year, or an investment that pays you 13.8%[sup]1[/sup] per year? (Hint: the bigger number is better in this case.) Putting X amount of money towards a fixed-rate mortgage at 3.5% is an investment that returns 3.5%. That’s not a great return for any investment, and your cash is now tied up in equity, where it can be hard to get at. Putting that same cash in the 13.8% investment and leaving the mortgage alone gets you a net return of 10.3%, and the investment is liquid.
Again, there’s nothing wrong with paying down your mortgage if that’s what you want to do. You’re not Apple and you don’t have a responsibility to play things strictly by the numbers. But you should fully understand the the consequences of your decision before you make it.
[sub]1. median annualized ten-year return for the S&P 500[/sub]
An index fund is a special type of mutual fund. Mutual funds are investments that anyone can purchase which buy a range of stocks with a particular strategy. For example, a mutual fund might invest in a basket of companies that make widgets, or companies with high dividend yields, or small companies with high growth potential. The fund is managed by a guy who is paid big bucks (out of the fund’s money) to decide what to invest in.
An index fund does away with the guy (and his cost) and just invests in the stocks in a representative stock market index, such as the S&P 500, on the theory that the market as a whole is a better long-term investment than trying to pick individual stocks. (Of course, 500 companies is not the whole market, but it’s designed to be a good representative sample.)
Vanguard has a stellar reputation and they invented index funds. It’s easy to create an account online if you’re interested.
An index fund is a way to invest in a large cross-section of the stock market without having to buy individual stocks.
Vanguard is a popular one, as mentioned earlier, and I can put in my own vote of confidence as well. The Vanguard 500 fund in particular is a good one. It represents the 500 largest US companies and has very low fees. There’s a $3000 minimum, though.
My advice is to dump money in an index fund after one has several months of emergency cash saved. The fund is easy to get money from, but you can’t write checks from it, so you need some kind of shorter-term buffer in case of emergency.
One of my thoughts as well. I haven’t made a car payment since 1999 or 2000 because I save before I buy so I don’t need to finance/pay interest.
Frylock, if that need isn’t in the short term jumping in to something less liquid like a mutual fund is a good step. It’s still got the ability to sell quickly but it’s better if you aren’t stuck selling at a low point because you need it liquid at a specific time. Either a broad index like an SP500 index or something even more diversified like a balanced fund which combines bond and stock holdings is a nice start.
I’m not sure how you came up with that figure (median return?) but the annualized 10-year return on the S&P 500 is nowhere near 13.8%.
friedo probably got it here.
Thanks.
Note that those returns are bogus for two reasons: 1) there are only 3 nonoverlapping 10-year periods included in the data set, making the calculated “median” value rather suspect, and 2) we actually have good data on the S&P 500 index going back to 1926 which show rolling 10-year average returns that are far lower.
In fact there have been 4 10-year periods where the CAGR of the S&P 500 was actually negative (several more if you account for the effect of inflation).
Bottom line, using a 13.8% expected return for planning purposes is absurd.
OK, but my basic point still stands. A market investment will usually have a better long-term return than paying down a low fixed-rate mortgage.
What is the student loan rate? I mean, income-based repayment just affects what you have to pay any given month, right? you still have to ultimately pay down the whole thing, and interest continues accruing, right?
If so: go ahead and throw extra cash at the student loan, even if only a few dollars a month. You’ll pay it off that much sooner and save money in the long run.
Of course the downside of paying that down (or the mortgage) is that money is “gone”, i.e. not something you could tap like a CD or other investment - so I wouldn’t try to pay them down without also doing what others have suggested (saving via CD or index fund, building up the rainy day fund).
Aside from that, I’ve got nothing beyond what others have said.
Are you sure you are taking care of all tax-advantaged space, including 401(k), IRA, and HSA?
If so, then I agree with the general approach of splitting excess income between paying down fixed-rate debt and investing in a index mutual fund (I prefer Vanguard’s total stock market to S&P 500, but they are very similar). I know that investing entirely in equities is more likely to have higher returns, but I have a specific financial goal that relates to paying off the mortgage.
More generally, you should make a investment policy statement that defines your goals and then outlines your strategy for achieving these goals. You can see more here: Investment policy statement - Bogleheads
Then your should direct that “extra” money to a specific goal, which should tell you exactly what to do with it.
Interest does accrue, but you only have to pay for 20 years. After that, the remainder is forgiven. This is a taxable event but of course the amount of the tax is (by definition!) only a fraction of the debt remaining.
(Actually in my case, it’s only ten years, and it’s tax free, because I work for a non-profit.)
403(b) and HSA, yes. IRA, no. What should I do in that regard? And can it be shown that the tax advantage is actually worth it, per the numbers, compared with other things one might do with money?
3.5% guaranteed would be higher than any fixed rate he could get in the market today. Like any investment, it depends on his investment time frame and how much risk he wants to take.
Start putting money into a Roth IRA. The investment is going to be better than other options (if you don’t have high interest debt to pay down), because you can make the same investments you would otherwise be making, but the investment growth will be tax free. You can put $5,500 per year into a Roth (or $6,500 if you’re 50 or over). A Roth can be set up at any discount brokerage, and can be set up to draw automatically from your bank account and to automatically invest in your chosen investment, making it simple and painless. Like others above, I would recommend that you invest in index funds. Then just sit back and wait until retirement, when you will be able to withdraw your money tax-free.
The other advantage of a Roth is that any money you put in (but not the investment gains) can be withdrawn at any time without tax or penalty.
I always forget to mention that it’s possible that you’re ineligible for a Roth because of the income limits:
Single filers: Up to $116,000 (to qualify for a full contribution); $116,000–$131,000 (to be eligible for a partial contribution)
Joint filers: Up to $183,000 (to qualify for a full contribution); $183,000–$193,000 (to be eligible for a partial contribution)