Money Forward

This blog is about money and trying to keep my money from flying out the window.

Wednesday, January 24, 2007

Saving vs. paying off loans

This question is being asked for the Carnival of Under 30 Finances, and I thought i'd answer:

Assume you are an average 25 year old with $25,000 debt (on account of your student loan) You have been given a lump sum $10,000 and the following four choices:

  1. Invest it for your retirement funds.
  2. Save/invest it for your future home.
  3. Save/invest it towards your child’s/children’s future college education.
  4. Pay part of your student loan debt.

You can pick only one of the above choices towards which you should use the entire $10,000. Which one will you pick? ..and Why? Assume that the rate of return on the three investments choices is the same and the student loan charges you an interest rate that is equal to this rate of return. Would your answer be any different if the amount was $25,000 instead of $10,000? Again, you can pick only one of the choices.

This isn't the easiest question since there are so many things to consider. I do know that I would definitely not do #3 (even if I had children). I stick with the idea that you should invest for yourself and do what you can for yourself first. I took out loans to get through school, and I know my children will be able to. Not only that, but I want to limit the amount my children have so that they will not be denied all financial aid. Of course, it would be ideal if I could just use my own money to pay their tuition.

To make it more complicated, if the $25,000 in student loans is spread out over several loans, I would pay off some of them. This would lower my monthly payments, allowing me to put that extra money into savings. This way I'm not losing as much money on the loan interest and I can have more money from my take-home pay to work with.

If the money was all in one loan, I would probably invest it in an investment account to save for a house. If I need to, I would pay off extra of my student loans as time goes on, but I would rather have the kick-start investment. The loans generally aren't so horrible that I can't handle them for a few more years. Also, I need as much help as I can get considering a 20% downpayment for a decent house in my area will be between $70,000 and $100,000.

If it was $25,000 instead, I would definitely put the money in investments to save for a house. The loan will continually be paid down, and so the interest will be less over time, while the amount of interest gained from the investment will increase. Plus, since the $25,000 would be unexpected, it wouldn't make a difference to my current budget, and so I could leave the money to grow somewhere without really thinking about it.


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