WCI #5: Paying Down Student Loans Versus Investing

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here's your host, Dr. Jim Dahli. Welcome to the White Coat Investor Podcast Number five.

If you're finding our podcasts informative and helpful, we would encourage you to sign up for our monthly newsletter. It is totally free and includes useful, actionable information not available the regular blog posts or this podcast. It's almost like being in a secret club. The kind of club that can boost your knowledge and enhance your wealth at the same time with no strings attached. Sign up today@whitecoatinvestor.com Newsletter. You can do this and the White Coat Investor can help.

Thanks a lot. For those of you who have been listening and telling others about this podcast, we're really having a great time doing this. Please continue to send your feedback and any questions you may have that you want answered on the podcast and be sure to give us a great rating so that we can share this message with as many other high income professionals as we can. Remember that I'm not a financial advisor or an attorney or an insurance agent and nor an accountant. And so remember the information you get here is for your entertainment and educational purposes only. Be sure to verify with a reliable source any information you get here before acting on it. Probably driving into work or home from work at this point. And I want you to know that what you did today or what you're about to do today actually matters. So sometimes it feels like it doesn't when you're slogging through your work, but it's an important benefit to those in our society, particularly those of you working with very ill patients. Never forget that what you do matters. And that's part of the reason I feel so passionately about supporting you in your financial life is because you're spending so much of your life really helping out those around you. Today we're going to talk about the eternal debate. I get questions about this seemingly every week, about student loans versus investing or really any kind of loan versus investing. When do you pay them down? When do you invest the money? And so we're going to talk about everything you should be considering in making that decision. The first thing to consider is what I like to call the power of focus. And there's a lot of benefit to focusing on one goal until you can knock that goal out. And I think it's important that we don't discount that that power is what allows a lot of people to really find financial purchase in their lives. For example, I had a guest post a few years ago from a general surgeon who literally paid off her student loans by Christmas after graduation from residency. And the way she did that was focusing everything on that goal. All of her extra money went toward that. In fact, even the money that was due for taxes went toward that because she was in a safe harbor where she didn't actually have to pay the taxes on the money she was making until the next April. And she had time from the first of the year until April to save that money up. So even the money that was technically supposed to go to the tax man she put toward her student loans and ended up being out of debt by Christmas, which really demonstrated to me the power of focusing on your goals. And so I think sometimes, while it might be wise mathematically to spread your money around to a bunch of different goals, sometimes behaviorally focusing on one at a time can really give you purchase. The next thing to consider when weighing whether to pay off loans or invest is what your current loan interest rate is. For example, if you've got a credit card at 25%, that's going to be a pretty darn high priority for your extra cash, whereas a loan at 2% might not be nearly as high of a priority. The current interest rates in our economy are also an important aspect of deciding whether to invest or pay down student loans. For example, if you can buy a CD, a one or two year CD that's paying you 5%, and, and you've got loans at 1 or 2%, well, maybe it makes sense to use that money to buy the cd, which is guaranteed and insured by the fdic, rather than paying off the loans. And so what's available out there for very safe investments should also be considered when deciding what to do with your student or mortgage loans. You also need to consider the effects of inflation. For example, I had one student loan between undergraduate and, and my medical school, thanks to a scholarship I had as an undergraduate. And because the military paid for medical school, I took it out in 1993. It was about $5,000. It was from the Alaska State government, and it was a particularly good loan. Although the rate wasn't very good, I think it was 8%. The terms of the loan were exceptional. Basically no interest accrued and no payments had to be made while I was in undergraduate, medical school, residency, or serving in the military. So when I got out of the military in 2010, I paid off that loan Basically with the equivalent of $3,000 in $1993. So I borrowed 5,000, paid back 3,000. That was a great deal. And so you got to take into account inflation when you're looking at your loans. If Your loans are 1% and inflation's running at 3 or 4%, while holding on to that debt actually allows you to pay it back with less after inflation dollars than paying it off. That in mind as well. When deciding between paying off debt and investing, you also want to consider your expected portfolio returns. If you're expecting to make 6% on your portfolio and you've got debt that's 7 or 8%, obviously it makes sense to pay off the debt instead. Likewise, if your Debt's only at 4 or 5%, it may make sense to invest and try to make six. But bear in mind there's additional risk associated with investing and so you can't just make a direct comparison. You also have to adjust for the amount of risk you're taking. Also consider your current tax bracket. You don't want to just look at the straight percentages. You actually have to adjust your interest rates for taxes. Your effective interest rate may be very different. For example, most attending physicians can't deduct their student loan interest, but they can deduct their mortgage interest. And so you have to adjust your mortgage interest down. For example, my mortgage is 2.75%, but after tax I figure I'm probably paying about 1.6% on that, which is a lot better interest rate. Likewise, you need to consider your available tax advantaged accounts. If you have not yet maxed out your 401k or defined benefit cash balance plan or other accounts, including tax free accounts like a Roth ira, you may be better off putting money in there than paying off your loans because of how those tax advantages and asset protection really are going to compound over the coming decades. You also want to make sure that you're getting any available match from your employer. If your employer is going to give you 50% or 100% of the first 6% of your salary, you put in the 401k, if you don't put that money in the 401k, you're leaving part of your salary on the table. And that's really pretty stupid no matter how high the interest rate is on the debt that you're paying off instead. So always be sure to get the match from your 401k. Your attitude toward debt is also an important aspect of deciding when to pay off debt and when to take out and when to Invest if you really hate debt, you're probably going to lean more toward paying it off. Whereas if you're somebody that's relatively debt tolerant, you may be more than willing to carry debt later into your career, maybe throughout your career and even into retirement. But in general, those who are more debt averse are going to want to pay their debt off sooner, and that should be weighed in. You also want to consider your own personal risk profile that includes both your attitude toward risk and your need to take risk. For example, some people just do not invest very aggressively because they do not like the volatility of their investments. They don't like investment risk. Now, people whose portfolios are not very aggressive and don't have a very high expected return should be more to pay off debt than to invest. Likewise, those who are willing to take on a lot of risk with their investments may come out ahead actually investing in a leveraged manner by carrying their debt and paying and investing while still carrying the debt. You also want to consider your need to take risk. For example, if your number that you need to retire is 3 million and you've only got 300,000, well, you've got a pretty significant need to take risk. And so maybe it makes sense for you to continue to carry debt while investing as opposed to paying it off. Whereas if you figure you need 3 million to retire and you've already got 2.8 million, you don't have nearly the need to take risk that the previous investor would have had. And maybe it's time for you to start deleveraging and paying off the debt in your life. In my book, the White Coat A Doctor's Guide to Personal Finance and Investing, I kind of tried to put together a list to give new attendings some financial priorities, and I'd like to go through that here because I think it's really useful for people to have a concrete list. They can just tick down and knock things out as they go. So the first thing on my list, as you might imagine, is get the match. If your employer is giving you a match, you got to get that because it's part of your salary. The second thing on the list is to pay off any high interest debt. If you've got debt that's 8% or higher, that ought to be a huge priority for you to pay down. Chances of you getting that out of your investments are not high over the long run, and certainly not high once you adjust for risk. Next, you ought to be maxing out any tax deferred retirement plan you have and the reason for that is because there's an extra return associated with that. The vast majority of physicians using a tax deferred retirement plan are going to take money out of that retirement plan in retirement at a lower overall tax rate than the savings they got when they put the money in. This should be a huge priority to you. Next is a health savings account. If you're eligible for one. This triple tax free account is awesome, but it's also a huge tax deduction that you'll miss out on if you don't fund that account. Next, I suggest you fund a personal and a spousal backdoor Roth IRA that doesn't give you an upfront tax deduction. But that tax free compound over the coming decades is going to be very valuable to you. Next, if you have children, I suggest you fund a college savings plan for each child up to the amount that your state subsidizes with tax breaks. For instance, in my state, the first $4,000 that I put in a 529 account for each child gives me a 5% state tax credit. And so I try to do at least $4,000 a year for each child. And I think that's a reasonable thing to do before moving into paying a moderate and low interest rate debt. Next, I suggest you pay off your moderate interest rate debt. That's debt of 4 to 8%. That's most student loans, particularly those who've refinanced them. Unless you're anticipating forgiveness, I think that's probably ought to be your next financial priority. Next, if you didn't use a physician mortgage loan to buy your house, I suggest you save up for a house down payment. That saves you not only private mortgage insurance or pmi, but it also saves you interest and fees on your mortgage. You just get a lot more options when you can use a conventional loan instead of a doctor loan. Next, if you used a doctor loan, pay it down to enable you to refinance into a lower rate conventional mortgage. That of course assumes interest rates haven't gone up since you got that mortgage. It's possible if they have that you can't refinance into a lower rate and you're kind of stuck with the one you have. Next, add additional funding if you desire to your college savings accounts, your 529s. After that, you can invest in a taxable account in risky investments such as stock index funds or real estate. Next, pay off low interest student loan debt. I'm talking 1 to 3% student loan debt unless you're anticipating that debt being forgiven. Next, you can make some extra payments on your mortgage. Next, invest in a taxable account in low risk investments such as municipal bond funds, etc. Finally, if you've done all that and you really are saving enough to meet all your financial goals, feel free to spend your money on whatever makes you happy. But bottom line is, there's a lot to consider when you're trying to decide whether to pay down loans or whether to invest. There is no right answer. But if you're not investing much and you're not maxing out your tax deferred accounts, you may not want to pay down any debt other than very high interest rate debt until you've done those things. The truth of the matter is I think most young attendants ought to be doing all of this stuff at once. That's why I recommend they live like a resident. What I mean by that is you live on about the same amount of money you're living on as a resident and taking the difference between your attending salary and your resident salary and putting it toward these financial priorities. If you are really doing that for two to five years after residency, you can max out all your retirement accounts, you can pay off all your student loans, and you can save up a nice big down payment just by controlling your lifestyle. That's the wonderful thing about a doctor income is you can do it all at once if you'll really just stay disciplined. All right, let's move on to a couple of questions I've gotten. This one came in via email I believe. Just starting to explore the idea of tax loss harvesting with my taxable account, but I'm trying to understand some of the rules regarding wash sale rules. If I want to harvest a loss in my taxable account, for example, going from the Vanguard Total Stock Market Index Fund to the Vanguard 500 index fund. But within 30 days I automatically have money in my HSA invested into the 500 index fund because my company does automatic payroll deductions. Is that considered a wash sale violation? Essentially, Are HSA transactions figured into the wash sale rule? Also, I have the same question that applies with 401ks and 403bs. Are automatic investments made within employer sponsored accounts subject to the Wash Sale rule as well? I know they are with an IRA or a Roth ira. Well, as I understand it, I don't think this has actually been tested in tax court, but I would expect because it applies in IRAs, it's going to apply in 401ks, 403bs and even HSAs. If you have tried to get a tax lost in your taxable account and then you turn around and buy the same fund or the same investment inside a tax protected account, that's technically a wash sale violation and you cannot use that tax loss on your taxes. I mean, you can do the sale, you just can't deduct the loss. And the truth of the matter is nobody's probably going to find out. It would have to be a pretty comprehensive audit for somebody to actually notice that. I don't recommend you do it just because no one's going to catch you, but realize that this is a pretty small potatoes thing for the IRS to worry about. The best way to deal with this is simply to when you do tax loss harvesting, which you probably don't do all that often, only when the market's really tanking, just don't buy the same fund for the next 30 days inside any account. It's not that hard to keep track of just to put it in a different account or leave it in cash for 30 days or whatever. But it's really not that hard of a thing to work around in my opinion. Even though I'm using the same mutual funds and 401ks and Roth IRAs and HSAs and my taxable account, it's just not that hard to work around this sort of a thing. You got to be careful though, if you've got an automatic investing plan because it may invest you into that investment automatically. So you may have to stop that for a month if you've done some tax loss harvesting recently. Next question. Do you consider the emergency fund as part of your portfolio or not? And there's probably no right answer to this question. It's reasonable to consider it if you want, but the way I look at my portfolios is I look at all the accounts and money designated for one goal and treat that all as one big portfolio. So with my retirement account, that includes a taxable account, it includes my wife's and my backdoor Roth IRAs, it includes both of our 401ks, it includes my old 401k, it includes my defined benefit cash balance plan. I look at it all together as one big account. Likewise, when I look at a different goal, such as college savings, I look at all accounts dedicated toward college savings as one big goal. But since I see the goal of an emergency fund as being totally different from a retirement portfolio, consider those two separate goals and two separate accounts. So I don't add my emergency fund in as part of my retirement portfolio. It's all in cash anyway because I want it to be accessible and liquid, and I don't really care that it's not earning a great deal of interest. The point of that is to allow me to take risk elsewhere in my portfolio and to allow me to take risk in my life without having to be awake at night wondering where the money to pay the bills in the next few months is going to come from. Alright, the quote of the day today comes from Seth Godin, who said, instead of wondering when your next vacation is, maybe you should set up a life you don't need to escape from. Boy, isn't that true? That's what I've really been working on these last couple of years is trying to mold my life into what I really want it to be rather than trying to get to as early as possible of a retirement as I can get. I just think it's far better to live your entire life the way you want to rather than deferring everything for your entire life.

If you're finding our podcasts informative and helpful, we would encourage you to sign up for our monthly newsletter. It is totally free and includes useful, actionable information not available on the regular blog posts or this podcast. It's almost like being in a secret club. The kind of club that can boost your knowledge and enhance your wealth at the same time, with no strings attached. Sign up today@whitecoatinvestor.com newsletter. You can do this and the White Coat Investor can help.

Thanks a lot for listening to the podcast. I hope you're enjoying it. Please support our sponsors and be sure to give us a great rating so that we can share this message with others. See you next time.