How should I balance investing with paying off student loans, credit card debt and a mortgage, as a 25-year-old?
I am 25 years old and I earn $90,000 per year. I have $30,000 in student loans (12% APR ), $10,000 in credit card loans (19% APR) and about $400,000 in a mortgage (4.75% APR). I also have $50,000 in stocks that are performing very well. I would rather invest my money than pay off my debt, but I know that's not an option. What's the best way to manage my debt? I could make the maximum contributions to my 401(k) early every year, then take out a 401(k) loan and "cycle" it to pay off debt, starting with my credit card, then my student loan. Or I could use post-tax money to pay down my debt. Using a 401(k) loan is more appealing because interest returns are lower than my stocks and post-tax money.
This is a great question and one that comes up often. There is an optimal path here in paying down debt and investing, and you're smart to think you should be doing both because you're right. Here is the order:
1. Emergency account (3-6 months of living expenses)
2. 401(k) savings to maximise employer match if available
3. Additional payments on higher interest loans (loans above 6% interest). For you this is your credit card and student loans. I would follow the Dave Ramsey waterfall plan and focus on your credit card first. Once you have the credit card paid off take that amount and apply it to your student loan payment plus whatever minimum you were already paying.
4. Additional 401(k) savings up to the maximum contribution
5. Additional payments on lower interest loans. This typically does not include a mortgage, but you could add extra here to the mortgage if you wanted.
6. IRA contributions
7. Taxable accounts
You mention having $50,000 in stocks. If that is in a taxable account instead of a Roth or Traditional IRA then I would start using those funds to make your Roth IRA contributions every year. You still have access to your Roth IRA contributions if you get in a bind, and it's much more tax efficient then leaving it in a taxable account.
When you're considering taking a loan on your 401(k) I would encourage you to instead pay down your debt with post-tax money from your income. You are right in that the interest is low on the 401(k), but while it is part of the loan that money is not invested in the market. In addition, as long as you're working for that company your employer will take part of your paycheck to pay down your loan. If you leave that company then you typically are only left with the option of paying back the loan in full. That could limit your flexibility if someone else approached you with a nice job offer.
You may want to consider refinancing your student loans if you think it will take some time to pay them back. Here is a great resource that we provide to our medical students.
Hope that was helpful. Feel free to email me if you have follow-up questions.
Matt Ahrens, CIMA®
This is an interesting scenario. It seems that your debt to income ratio is too high. How much is your home worth? Also, your assets to liabilities ratio is bit low as well (I assumed a home value of $500,000). It would be helpful to take a look at your monthly expenses and net income. What type of student loans do you have that are 12%? That seems quite high. Taking a loan from your 401(k) would not be my first option. Please read through your plan details to review their policy on loans. I have a few options that could potentially save your $17,000 in interest on your loans and could potentially help pay off your debts 71 months sooner. But, I would need more information before I can make an actual determination. This is just my best estimate using the information at hand, guessing a few numbers, and extrapolating.
I think this could best be answered if I understood your monthly cash flow, and how much you're currently paying towards debt. However, without knowing that information, one option you may consider is to use the 50k in stocks to pay off the 30k in student loans and 10k in credit card debt. The 12% and 19% interest on those debts are likely higher than what your stock investments will earn on average over time. By paying off that debt, you're essentially "locking in" those interest rates at your rate of return.
The downside to using a 401(k) loan is you could potentially get double taxed. Meaning if you contribute to your traditional 401(k) you're putting pre-tax money in, when you take the loan you have to repay it with after-tax money, and when you make withdrawals in retirement you'll have to pay taxes again. Also, you must consider your employment situation, are you comfortable committing to stay at your current employer for at least 5 years or however long it will take to repay the 401(k) loan?
I think the best course of action is to get a plan in place or your cash flow and aggressively pay down the higher interest rate debts while assisting with your stock portfolio.
Hello 25, you are doing great! I'm 68 years old and here is what I would do if I were in your shoes.
First, don't get too caught up in stocks repeating the past. We've had a nice run but when things get dicey you are going to be in for a shock. At 25 you've never experienced a bear market. You were 15 during the last one and were likely not emotionally involved back then. You will be emotionally involved in the next bear market. You could easily wake up on morning and find that your investments are worth half of what they are now and that you don't have a job.
Second, I'd pay off the student loans first and the credit card second. Student loans scare the heck out of me because of the difficulty in getting out of them if your life takes a turn for the worst. I know the rates are higher on the credit card.
Third, you've reasoned out your options pretty well. If you sell stocks you might have the problem of taxes to add to your debt reduction.
Summary: You are in the good times right now. Use the good times to get out of debt. If things continue good you'll be more secure and if they don't, you'll be even more secure.
You have too much debt for your income. Get rid of the mortgage and all loans with your current income and assets. The start saving money more per month and invest them beyond your 401(k). Open a Roth account and an after-tax brokerage account and save your dollars there in diversified index funds or solid company stocks that are selling at disccounts. You need to do stock research or find an investment advisor who is very experienced in equity investments.