Two Pennies Earned

This post is for Dr. Mihm, who relies on my blog to get him through the day.

Recently, The V-Train and I paid off some of her student loans. Dr. Mihm called me a couple days later to tell me he was doing the same thing. The purpose of the call was to figure out a way to game the system to get airline miles from the loan payoff (we couldn't figure out how), but we got to talking about how good an "investment" paying off loans is right now.

These student loan interest rates were at about 6.5%, so paying them off is essentially a 6.5% return -- risk free. There is no other risk-free or even low-risk investment paying anywhere near 6.5%, so this is a very reasonable "investment" option. Dr. Mihm mentioned that after maxing out the 401ks, paying down the student loan was the next highest priority.

But should you max out the 401k first in this instance at the expense of paying down the loan? I'll make an argument that maybe you should not. The first thing to realize is that paying down a non tax-deductible loan (car loan, credit card, student loan for some people) gives you the equivalent of a TAX FREE return at the interest rate. Let's do the math. Say the interest on your non tax-deductible student loan is $500. To pay that $500, you would have had to earn $500 after tax, or $685 in gross salary if you're at the top 28% marginal tax rate, plus 9% for California taxes. Andrew Tobias put it best when he said "a penny saved is two pennies earned" (tax rates were a little higher back then, and federal plus state taxes added up to nearly 50%).

So even if a 401k were tax free, you'd have to earn 6.5% in your 401k for it to be a better deal than paying down the student loan. Will your 401k earn 6.5%? Well it could, but it's not guaranteed the way the 6.5% return from the student loan is. Warren Buffet has, in his last letter to Berkshire Hathaway shareholders as well as in interviews, expressed great skepticism that the market will continue to return 8%. A 6.5% risk-free return is unheard of right now so it's really a great time to pay down a 6.5% loan.

But to make matters worse, a 401k isn't even tax free. It's only tax-deferred. At some point, you're going to have to pay your 37% tax on that money... unless tax rates go up. So you'd have to earn a somewhat higher rate than 6.5% to make it the equivalent of paying down the loan.

So what's the interest rate at which I'd pay down a loan rather than invest in the stock market in a taxable account? Well let's assume a conservative return for the stock market over the next few years since we're comparing against a risk-free option -- I'll go with 6%. Let's further assume these stock market returns would be taxed at the current 20% capital gains rate (though the likely next president has indicated he'd like to raise that rate) and your after tax return would be about 4.8%. Therefore, I'd pay off any loan with an interest rate higher than 4.8% vs. putting the money in a taxable account.

All in all, with interest rates plummeting, it's a good time to re-evaluate your debt, and maybe move the line that separates your "good debt" from your "bad debt".

How Underpaid Am I?

Wow. A co-worker and close friend of mine, who has the exact same job that I have, and who's current salary is the same as mine, just got a job offer that knocked him flat.

- This job is compensated so much higher than our current job that I could tell you his salary today and it wouldn't help you guess the salary of the new job.

- If you wanted to express the relationship between the two salaries as a circle, the old job would be the diameter, and the new job would be the circumference. Then you'd have to add a line or a lump or a funny hat to the top of the circle to make it accurate.

- If he wants to save half his new salary, and only half his salary, his spending will have to increase dramatically.

- His salary has increased so much that if it were expressed in British pounds, and you accidentally misread it as dollars, you'd still be impressed at how much of a raise he just got.

What does this mean for me? Sadly, very little in the short term. I'm not terribly underpaid in my industry or compared to my b-school graduating class, and the odds of me going out and finding a job like this for which I'm qualified are very close to 0. Even though we have the same job today, he was actually uniquely qualified for this job, and it's just dumb luck that the stars aligned to put him in it.

The good news for me in the long term is that my "network" now contains yet another person who's compensation can be expressed as a large improper fraction of mine. Maybe I can be his lackey or something and draft off his success.

How to Tell When I've Stopped Caring About My Job

How to tell when I've stopped caring about my job:

- I stop shaving and wearing slacks, or otherwise abandon pretense at maintaining a professional appearance.

How to tell when I've really stopped caring about my job:

- I mostly do the above, but I occasionally show up in a suit. You know, just to mix it up.

You CAN get by on $496,000 per year

My favorite personal finance book is a short one by Andrew Tobias: The Only Investment Guide You'll Ever Need. Over the years I've read it many times and given several copies out as gifts. As I am utterly incapable of producing my own topical content, I thought I'd free-ride on old Andy for a while, and tell you about one of my favorite chapter titles of all time.

The title of the chapter is "You Can Get By On $165,000 Per Year". Now if you live in California or New York, you're probably thinking to yourself "well, what's so strange about that? I mean I wouldn't want to have to do it, but I think my mom's cousin gets by on less, and so does this one guy I met at the bus stop, I'm pretty sure." Ah, but this book was written in 1978, when $165,000 was worth $496,000 of 2008 dollars. That's a lot of money even in Cali.

The point, dear readers, is that most people feel like they are stretching to get by on their income. But since there is such a huge range of incomes in the US and A, it can't actually be the income that causes this. Someone who lives above his means is likely to do so whether his income is $15,000 or $150,000. And someone who stays under her budget will manage to do so at a range of incomes as well. So if you're struggling to make do on your salary, odds are that getting more money won't solve the problem.

Or to paraphrase Andy again, since I don't have his book in front of me to plagiarize: $20,000 earned, $19,000 spent = happiness. $19,000 earned, $20,000 spent = misery.