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".