Reference no: EM131504319

Should you make an investment or repay your student loan early? Suppose it is June 2017, you are 28 years old, and you anticipate graduating with $50,000 of student loans. Following a grace period that runs until December 31, 2017, interest will begin to accrue on your loan at a rate of 5% per year. For simplicity, assume the loan calls for repayments in 6 equal, annual installments, beginning on January 1, 2018 and ending on January 1, 2025. There is no penalty for early repayment. Note the date of the first payment on this loan occurs before any interest has accrued. Verify that each payment will be $9,381.78. **Hint: While there is no penalty for early repayment, making an early payment on a loan is NOT the same thing as refinancing a loan (i.e., your monthly payments will not change)

By December of 2017 you can spare $1,000 net (after-tax) -cash outflow to either invest or pay down your student loan. Following graduation, you take a several month vacation to ____ (insert your destination of choice). Since you will only have worked a few months in 2017, your income will be low enough that you can make a fully deductible contribution to an IRA for 2017, if you so desire. Your income after 2017 will be too high to make a deductible contribution. You anticipate cashing out of any investment you make to use towards the last payment of you student loan. You can earn a 4% pre-tax annual return in a corporate bond fund. [Imagine we live in a world where interest rates are actually that high and the return on bond funds comes entirely in the form of interest.] Your marginal tax rate is 20% in 2017, increasing to 35% thereafter. You have no existing IRA investments and do not expect to make any in the future. Assume there is no tax deduction for student loan interest.

You have 4 choices:

1. Repay $1,000 of your student loan early,

2. Invest in a corporate bond fund outside an IRA (i.e., invest via a taxable brokerage account),

3. Invest in a corporate bond fund via a deductible IRA contribution, or

4. Invest in a corporate bond fund via a non-deductible IRA contribution.

If you invest outside the IRA, assume that all of the returns are ordinary income. Early withdrawals (before age 59.5) from an IRA are subject to a 10% penalty -- I advise you to look up and become familiar with these rules.

A) Compute the after-tax effect on your wealth after the last payment of your student loan for each of the 4 alternatives. Which alternative maximizes your after-tax wealth?

B) Redo part (a) assuming you can earn 8% pre-tax return in the corporate bond fund.

C) Same as part (b), but suppose that after 3 years you decide to change careers and pursue your dream of being a children’s book author. Consequently, your marginal tax rate is 35% from 2018-2020, after which it permanently drops to 20%.