PP and loans (mortgage, student, or otherwise)

[DavidMD]

Hi All,

Like most of you, I'm attracted to this asset allocation model for, among other things, its straightforward approach and the enormous amount of sense that it makes. I thought I would bring up a topic that I had been thinking about.

For a young person, does it make sense to have a 25% allocation to long term treasury bonds if you have a student loan with 6.8 - 9.0% interest?

Right now, putting capital into TLT (a proxy for long-term treasuries) yields 2.49%, whereas paying extra toward the principal of student loans would save you from paying a much higher interest expense, giving you a quasi yield of 6.8%-9.0%. Granted student loan interest is deductible to a limited extent, a person doing this analysis would obviously have to adjust these rates to determine the interest rate they are actually paying. However, for someone with a typical salary, the student loan interest rate is still much higher (~6.3-8.5%) than the treasury yield.

Given that, what should this person do? They have 20k in savings and 40k in student loans with an effective interest rate of 6.3%; for the sake of argument, let's say they have a separate emergency fund or live in their parents' house.

Now some of you may argue that they should pay off all of their student loans before doing ANY investing. My rebuttal to that would be that's quite reasonable for this person to want to repay debt faster AND build an investment portfolio at the same time. This would allow them to gain exposure to the upside potential of various assets while also paying down their principal faster.

Now how should this be done in the case of the young working person with 20k in savings and 40k (at 6.3% interest) in student loans in the context of a permanent portfolio? Here's a thought I had, what if they treat the advance principal payments on the loan as their long-term bond holding instead of TLT? They could track the amount of their advance payments and track the amount of saved interest expenses and make sure they are eventually re-funneled into the portfolio. It sounds like a better asset management method than simply buying treasuries for the sake of orthodoxy.

One issue I can think of offhand is that of liquidity when it comes to re-balancing. In the case of long-term bonds outperforming, a traditional PP person might be selling shares of TLT to allocate to gold or stocks; however, for the person in our example, the money used to pay principal down on the loans is completely inaccessible. This is certainly is an issue; however, I think this is not a huge concern IF the person in question is investing money monthly and can contribute new savings to whatever parts of the portfolio are underweight. Of course, when all is said and done, and the student loan is paid off, I think the person should re-balance the portfolio back to the traditional standards.

What do you guys think?

[DavidMD]

Also, another issue I just thought of is that one might miss out on any upside of the nominal values of the bonds themselves, not just the yield (as reflected by the share price of TLT). However, I think this concern is somewhat small given the current state of our treasury bond market (haha).

[MediumTex]

If a person chooses to invest rather than pay down debt, the PP is a safe and simple way to do that, and part of that safety comes from having exposure to LT treasuries.

If you start monkeying around with the PP allocation, though, the strategy loses its safety and simplicity.

Thus, I would first decide if I was going to use a given dollar to pay down debt, consume, or save.  If I chose to save it, I would say that the PP should be a serious choice for how to save it.

When it comes to LT treasuries, we don't hold them primarily for yield--we hold them primarily for potential capital gains.  Thus, comparing the yield on LT treasuries to the rate on a loan is, IMHO, misplaced.

[craigr]

I dislike debt. I would pay it off first. Especially if it is 6.3% effective rate.

[Gosso]

DavidMD,

Welcome to the forum!

With inflation running at 2%, that means the student debt is costing you between 4-6% in real terms.  I don't know about you but I'd be extremely happy with a 6% real return on my investments (this would be at the high end for the PP), with very little volatility, and tax-free.  There is the risk that we could see high inflation in the future which would reduce the carrying cost of the debt, but I wouldn't bet on that. 

I vote for paying off the debt, but maybe you'd want to maintain a small PP of $10,000 (take it for a test drive).

Regarding emergency cash, I don't see the need for a large stash of cash for a single-young-mobile-mortgage-free person.  Maybe keep 3-6 months of living expenses, but like you say it is possible to simply move back to your parents house until the economy recovers and a new job can be found. 

[Xan]

Keeping a debt around is a way to buy flexibility.  If used responsibly (big if!), it can be the right choice.

For example, say you plan to buy a house within the next couple years.  Suppose if you paid off the student loans, you'd have $x available for a house down payment, and if you didn't pay them off, you'd have $2x.

When the time comes to buy the house, and your goal is to put $x down, then you can certainly do that, and then throw the other $x at the student loans.  You've bought the option of being able to make a bigger down payment for the cost of some interest on the student loans.

[cabronjames]

look at the historical PP performance, in 2008 & 2011, to examples where the Deflation asset, 30 yr US Treasuries, carried the PP.  As MediumTex says, the Capital gain/Asset price increase of the UST-Bond is what powers its return, not its dividends.

1 alternative for investing while paying off your debt, would be to limit your investing to maxing the Roth IRA with $5K each year, & paying off debt with any other "savings".

[Pointedstick]

I'm with CraigR here. Paying down your debt is incredibly liberating, and once you're done, you can pile the (former) monthly debt payments into your investments without skipping a beat. That said, I'll admit I started investing a few years ago before I had my student loans all paid off. Debt repayment still remained the top priority, and I paid down $77,000 in a little over three years and I don't regret it one bit. I could have put that money into investments, but it almost seems silly to me to have a ton of investments and also a ton of debt. They're making you money, but then it's going right out the door in interest payments!

[Ad Orientem]

I dislike debt. I would pay it off first. Especially if it is 6.3% effective rate.

Ditto what Craig said. Dave Ramsey may be a bit hardcore in his anti-debt crusade, but broadly speaking he is right. "Debt" is a four letter word and IMHO should be avoided to the extent reasonably possible. In my entire life I have never once heard of a man going broke who wasn't in debt.

Assuming you have an emergency fund set up (6-12 months minimum of essential living expenses) I would give priority to dealing with your debt. Pay it down as fast as you reasonably can. If possible you might want to look into refinancing it at a lower rate. Yours sounds high to me.

P.S. Welcome to the forum.

[jackely]

Reminds me of the kinds of questions I get asked by my kids (and now my grandkids) when they get themselves into situations I never even dreamed of.

In this case however, I may be in a somewhat similar situation with an underwater mortgage.

Having read through all the replies I have the impression that my thinking may be very different from other PPer's but I have absolutely no intention of paying off said underwater mortgage. My philosophy is that I can take my money and run but I can't take my house and run.

And along the same lines I am now dealing with a second offer from Wells Fargo bank about modifying the terms of my mortgage due to government programs. So far it has only been changes in interest rate but I'm thinking if I hold out long enough they might even reduce the principal, which I have heard talk of.

If you pay off your student loan and Obama gets re-elected and cancels all student loan debt you'll feel pretty stupid won't you?

(And I just thought of this after I posted........)

I feel far less than 100 percent responsible for getting myself into the underwater mortgage predicament. I believe it was the government and the banks working together that drove up the price of homes. The banks are now getting bailed out by the government for their recklessness but us underwater homeowners are now left holding the bag and nobody is bailing us out.

I don't know as much about student loan debt as I do the subprime mortgage fiasco but I suspect it's a very similar story. If I was you I would maintain my integrity about paying my debts but paying off the student loan wouldn't be on the front-burner.

[Ad Orientem]

jackh
Setting aside ethical considerations I would make two observations. First in some states it is possible to walk away from a mortgage and just let the bank foreclose and they eat any loss. California is one such state. But in many others they can come after you for the difference if they end up selling the house for less than what they are owed. Secondly you can't just walk away from student loan debt. Even worse, it is exempt from bankruptcy. It stays with you until you pay it off, or you die.

[Pointedstick]

If you pay off your student loan and Obama gets re-elected and cancels all student loan debt you'll feel pretty stupid won't you?

I think the likelihood of this happening is near zero, but if it did, I would indeed feel very stupid. But then again if I paid the minimum for years (thereby giving thousands to the banks and the federal government in interest payments) and no friendly politician came along and benevolently canceled all the outstanding student loans, I'd feel pretty stupid for that too. One of my relatives is hoping for just that to happen, and I think her optimism that it will is part of the reason she's now more than $100,000 in debt with a worthless degree and a high school level job.

[sophie]

I agree with PointedStick - you're likely to lose the bet that the markets will return a higher rate than your loan, particularly taking taxes into account.  Have you looked into student loan consolidation?  You might want to talk to your lender about ways to get that rate down. 

The current student loan rates are frankly criminal.  Mine have an interest rate of only 2.3%.  What happened??  I do sense a backlash happening at some point, but as PointedStick says, it could be years in the making, and in the meantime you'll be bleeding money at high interest rates.

[hoost]

DavidMD,

Is this young person you? I find it somewhat interesting that, if it is you, you would refer to yourself in the third person in this situation. I think that this whole question becomes more clear when you start saying "I".  I have 20k in the bank, and I owe 40k in debt that I voluntarily signed up for.  Should I risk the 20k that I have earned hoping to make a return better than 6.3% without losing all of my money and still staying 40k in debt?

Personally, I would say no, I wouldn't risk the 20k or any other money.  I would pay off all of the debt as quickly as possible.  If you're an MD, your income will be such that you don't get the tax deduction anyway.  I've found that it's a lot easier, quicker, and more rewarding to focus on one financial goal at a time.  You'll pay off the debt twice as fast if you focus on doing only that, and then all of your extra can go to investing (although I'd build your E-fund and save up a down payment for a house first).

As a bit of background, over the last three years I paid off around $120k in debt and am now debt free (finally!).  I had the same mentality you did at first, but I found it much more rewarding once I focused solely on paying off my smallest debt. It's amazing how quickly it goes by when you're focused, and it's crazy when you realize how much interest you're paying.  Just remember that compounding works both ways.

Someone else mentioned the name before, but I would say I'm a pretty big fan of Dave Ramsey, especially his first three "baby steps".  I prefer the PP over his investment advice, but I think his personal finance advice is quite solid, and it has really helped me to get my affairs in order.

Also, if you have an extra emergency fund or live in your parents' house, use the extra money to pay off the debt.  Then build up a 6 month emergency fund.

[Gosso]

I have to say that I am shocked by the level of student debt being thrown around here.  I managed to graduate from one of the top engineering schools in Canada with only $25,000 in debt (I graduated in 2007).  I paid for everything myself and worked during the summers.  My average annual expenses were ~$15,000, which included tuition, rent, whiskey, beer, lap-dances, etc. 

What gives?  Am I simply the beneficiary of socialism?

DavidMD, sorry for the derailment of the thread.  By the way, did we help with your predicament?

[Ad Orientem]

I have to say that I am shocked by the level of student debt being thrown around here.  I managed to graduate from one of the top engineering schools in Canada with only $25,000 in debt (I graduated in 2007).  I paid for everything myself and worked during the summers.  My average annual expenses were ~$15,000, which included tuition, rent, whiskey, beer, lap-dances, etc. 

What gives?  Am I simply the beneficiary of socialism?

Yes.

[Gosso]

I have to say that I am shocked by the level of student debt being thrown around here.  I managed to graduate from one of the top engineering schools in Canada with only $25,000 in debt (I graduated in 2007).  I paid for everything myself and worked during the summers.  My average annual expenses were ~$15,000, which included tuition, rent, whiskey, beer, lap-dances, etc. 

What gives?  Am I simply the beneficiary of socialism?

Yes.

At what point do Americans stop attending university/college?  Or is it so ingrained in society that one must attend University to become a respectable citizen and find a job? (no matter the cost)

[Ad Orientem]

I have to say that I am shocked by the level of student debt being thrown around here.  I managed to graduate from one of the top engineering schools in Canada with only $25,000 in debt (I graduated in 2007).  I paid for everything myself and worked during the summers.  My average annual expenses were ~$15,000, which included tuition, rent, whiskey, beer, lap-dances, etc. 

What gives?  Am I simply the beneficiary of socialism?

Yes.

At what point do Americans stop attending university/college?  Or is it so ingrained in society that one must attend University to become a respectable citizen and find a job? (no matter the cost)

I think that's a very good question. I can only speak for myself. But right now I think I would hesitate before recommending a college education to young people unless they knew exactly what they wanted to do with it and knew with a reasonable degree of certainty how they were going to pay for it.

[Pointedstick]

I have to say that I am shocked by the level of student debt being thrown around here.  I managed to graduate from one of the top engineering schools in Canada with only $25,000 in debt (I graduated in 2007).  I paid for everything myself and worked during the summers.  My average annual expenses were ~$15,000, which included tuition, rent, whiskey, beer, lap-dances, etc. 

What gives?  Am I simply the beneficiary of socialism?

Yes.

At what point do Americans stop attending university/college?  Or is it so ingrained in society that one must attend University to become a respectable citizen and find a job? (no matter the cost)

Yes. Our whole baby boomer generation convinced their kids that college was a gold-plated ticket to success. The result: unprecedented numbers of less intelligent or academically unprepared kids enroll, causing the colleges to dumb down the curriculum and raise prices. My parents are both college professors themselves and have reported this trend over the past 30 years (they're also extremely liberal so it's not like they're just a couple of stogy young-people-hating conservatives or something). Their classes are routinely choked with kids who sleep through lectures, don't do the reading, cut many classes, write at the level of elementary school students, have difficulty verbally expressing themselves, or all of the above. And the colleges oblige them with mickey-mouse classes like "Comparative gender dynamics" and "African ethnography through maskmaking". My college was choked with classes like these, and they're a surefire ticket to a worthless degree. The rich selection of fun but useless classes just further encourages unprepared kids to attend college, which only pushes the prices up even more.

The debt figures are even more shocking for med school, law school.  One can easily rack up $150,000 of debt if one isn't careful. And in the liberal arts, it's easy to accumulate 40-80k, which is all the worse since you graduate without any marketable skills that might persuade someone to employ you. Even worse, many are so brainwashed with this "all college all the time" attitude that upon being unable to find any jobs due to their worthless degrees and lack of experience, they convince themselves that the problem is that they aren't educated enough and go off to grad school to waste a few more years and many more thousands of dollars that their future selves will be on the hook for.

I've seen this happen to dozens of my peers (I'm 25) and it just breaks my heart. My generation is starting life underwater, jobless, and bitter. I count my lucky stars every day that I was able to escape from those traps before I had gotten myself in too far. It would have been very easy for me to wind up one of those angry OWS protesters who realized he'd been sold a raw deal only after he took it.

[Bean]

I have been thinking about this very question

Would you pay down a 4%(3% effective), 30 year mortgage or add to a Permanent Portfolio?

I have an emergency fund and either route it would take ~10 years to pay it off or have a portfolio the size of the remaining loan balance with the amount I am willing to direct to this monthly.

[Pointedstick]

I would prefer to save up enough to buy the house outright, or better yet buy the land outright and build the house myself. But if I already had a mortgage, I would probably put money into it rather than a PP since I hate debt so much. It would actually make more sense to contribute to a 9% yield PP rather than pay down a 3-4% debt, but you have to know yourself and what makes you sleep best at night. For me, that's paying off the debt faster, even if it means giving up some investing time. You may be different of course!

[cowboyhat]

I think Ad Orientem makes a key point in thinking about your strategy in that student loans are a special kind of debt that can not be discharged by bankruptcy. As I recall the only ways to get get out of them are to do some kind of government service (such as teach in an inner city school) that includes loan forgiveness or become permanently disabled (ie go blind). From my perspective that makes paying off student loans a high priority. All the more so if you are paying 6+% and can't refinance.

To my mind, the exception might be putting money into a tax deferred account like an IRA or 401K where the yearly contribution limit is capped or where an employer is matching your contribution, because you can't get the opportunity to make those yearly contributions/matches back.

Mortgage debt is an interesting question because the money you put toward prepaying principle becomes illiquid. If you suffer a reversal of fortune it may not be possible to extract the home equity you have built for other purposes. However, having a completely paid off house may drastically reduce your need for cash flow, which may make you less reliant on being continually employed or needing to get access to your home equity. Could make sense to save rather than prepay mortgage with the objective of paying off the mortgage principle in one giant payment. The difference between the mortgage interest and return on savings would be like a home equity access insurance premium. One thing to keep in mind is that the premium will be higher than the APR on the mortgage minus return on savings due to the shape of the mortgage interest amortization curve.