If there’s one thing a terrible economy is good for, it’s paying down debt.
Despite having a net worth of over $20,000, I still have tens of thousands of dollars in student loan debt. Most people don’t understand why I would choose to keep student loans when I have the ability to pay them off, but it’s really simple. When you can invest money at a higher rate of return than the interest rate on your debt, you’re making money.
When the economy is doing well, it’s pretty easy to outperform paying off student loan debt by investing in the stock market. When the economy isn’t doing so well, it’s a different story.
The Europe debt concerns, a faltering American economy due to terrible economic policy coming from our president, and my own personally aggressive investing style have combined to form a massive ball of suck in my investments. I’ve lost enough money in the market this year and I’m ready to get returns elsewhere.
While I am still investing in my 401k to take advantage of low prices in the stock market, I’m not putting any additional investment into the stock market. I need reason to believe the economy will turn around, and the earliest I can see that reason coming along is November of 2012. That means I need to find somewhere else to invest my money for the next 14 months.
Enter my large amount of outstanding student loans.
Paying Down Debt is a Guaranteed Return on Investment
Being in debt sucks pretty hard, but if there’s one positive aspect, it’s the fact that paying down debt is a guaranteed return on your investment.
As of the beginning of this month, I had over $20k in student loan debt, ranging from 1.76% to 5.00%. Instead of taking my chances with an investment that might gain over 5%, but could also lose money, I’ve decided to pay off $4,717.76 of student loans at 5%.
If I had continued to make minimum payments on that loan until I had the entire balance paid off, I would have paid $938.40 in interest. That means future Kevin is about $1k richer. Take that student loans!
In addition to saving money in interest over the course of the loan, I’ve also improved my cash flow by $63.64 a month. Where I was spending that much every month to pay for the loan, I now have more in my pocket after all my bills are paid. Sure it cost me almost $5k to increase my cash flow by only about $60, but when you realize I had about eight more years of paying that crap, it really adds up.
Don’t Forget the Student Loan Tax Deduction!
For many of you out there with student loans, there’s another variable you need to consider in the equation of paying off your student loans. Interest on student loans is tax deductible, but only at certain income levels. You can deduct 100% of student loan interest (up to $2,500) if you’re making $60,000 a year or less. You can only take a partial tax benefit if you make between $60k and $75k. If you make over $75k, you get nothing!
I didn’t personally take that into account because, when you add up all the money at make at my day job with what I get on this website, I’m somewhere in that range. I honestly don’t know if I’ll be over $75k or below $60k, so I can’t plan for that benefit if I don’t know if I qualify.
If you make well under $60k, then just assume you’ll get the benefit. If you make around $60k or more, I recommend you just assume you won’t get it.
Kevin McKee is an entrepreneur, IT guru, and personal finance leader. In addition to his writing, Kevin is the head of IT at Buildingstars, Co-Founder of Padmission, and organizer of Laravel STL. He is also the creator of www.contributetoopensource.com. When he’s not working, Kevin enjoys podcasting about movies and spending time with his wife and four children.
I agree with almost everything you stated… except, “When you can invest money at a higher rate of return than the interest rate on your debt, you’re making money.”
Essentially you’d be willing to borrow money at 5% to get a historical 8% non-risk adjusted return, less inflation & deferring this taxable income to the future?
I wouldn’t. Just my two cents.
AND
People also need to understand the difference of a deduction and credit on tax returns. Student loans & mortgages are not a good thing so you can receive a deduction. Paying lots of interest, which then turns into a deduction, which turns into a smaller dollar-for-dollar credit.. Does not sound good to me.
Other than that, good post!
Inflation is a constant when you use leverage to make investments. You don’t have any exposure to inflation if you have $100 in liabilities and $100 in assets. Deducting inflation from returns doesn’t make sense here.
A deduction isn’t as good as a credit, but it’s still nothing to scoff at. Assuming a tax burden of 20%, his student loan interest only costs 4% at a nominal rate of 5%. There are whole segments of the financial industry built on the tax benefits of debt. These firms wouldn’t exist if it wasn’t profitable.
It is something to scoff at when you’re paying out interest to get a lesser credit. If someone is in the 25% bracket and pays $1000 in interest on a student loan. They get a $250 credit.
Pay out $1000 to get a $250 credit? Doesn’t make sense to me.
I agree with you about the tax benefits of debts for corporations. Yet, you’re speaking upon individuals here. These companies have credits and deductions galore and find loopholes in business tax structures.
Comparing apples to watermelons.
Ehhh…in a world where DR talking points were a substitute for thought, I’d agree with you. We’re not going to see eye to eye, but that’s okay. I see already where this is going.
I’m not trying to argue with ya bud.
I’m just saying, I don’t see how those ideas make sense. Those aren’t DR talking points. It’s math.
No one wants to pay $1000 to save $250 in a tax credit. The point is that you should take that into account when determining the true interest rate of the loan.
A loan at 5% where you’re getting 25% of the interest back in your taxes is really a loan at 3.75%. That’s the number you need to make more than to turn a profit investing elsewhere.
I get what you’re stating Kevin & JT.
I guess we’re at two different point of views, which JT stated above.
My argument takes a risk adjustment into consideration. Not only market risk, like yours, but risk of the unknown.
Layoffs, bad health, lawsuits, etc. I’d just rather be in a situation where there’s less burden if something goes wrong. AND, I don’t like paying interest.. at all.
Again, good points by both of you. I guess I was just being devil’s advocate? 🙂
Have a good one.
The point of a student loan interest deduction is the fact that a 5% loan is really a 3.75% interest rate for me if it reduces my taxable income. However, if you are phased out of that deduction because of income, then it’s obviously back up to 5%.
The student loan tax deduction is only good for everyone through tax year 2012. After that it will be only for interest paid the first 60 months of repayment: http://taxes.about.com/od/deductionscredits/qt/studentloanint.htm
Good post!
Great info Robert. I’m glad you shared that with me because I wasn’t aware. Makes me feel even better about paying off the loan, because I’ll be approaching 60 months of repayment in 2013
Very true, saving interest does provide a guaranteed return. I treat my mortgage principal reduction decisions the same way. Sadly, the rate on my mortgage note is probably higher than most student loan debt.
Yep, that’s another great way to get a guaranteed return if you have a house.
I’ve been debating paying off my husband-to-be’s student loans or investing the money. I agree that you can pay off the debt slowly while making greater returns on your investment, but have been hesitant to because of the market lately.
However, I’ve also been considering the Punch Debt In The Face idea of simply paying it all off with one fatty check to be rid of it forever.
This is a great post – perhaps I will do what you are doing and pay off a huge chunk of the loans and simply up our monthly payment. Then I can see if the market might sneak up a bit.
How did you calculate the exact amount of interest you would be saving? Is this compounded?
I just used the bankrate mortgage calculator. Sure, this isn’t a mortgage, but at the end of the day, a debt calculator is a debt calculator, no matter what kind of debt it is.
http://www.bankrate.com/calculators.aspx
Just put in what you owe and the number of months you have left of repayment, and it gives you the info in the amortization schedule.
We’ve reduced our student loan balance so much that the deduction is pretty minimal either way. Which is a good thing because it means we owe less 🙂
Owing less is definitely a good thing if your goal is to reduce debt!
We eliminated the final $13k of my student debt this year. We paid off $3k on a personal loan and we pay, in effect, 41.5% more every 2 weeks on our mortgage than the bank says we have to. We’ll increase that number to 62.5% Jan 1.
Sounds like you’re doing a heck of a lot of “guaranteed investing”. Good for you!
I agree with you that if I can’t make good money with the stock market (and I can’t in the near future), it’s worth taking off some of the loans and debts
We’re on the same page, that’s for sure.
Thank you for sharing these tips. Nowadays we have to face a rough economy period and find a way to survive…