Now that we all know that Good Debt exists, I want to talk about the best debt in the world: Student Loans!
I strongly suggest never paying off student loan debt that has a 5% or lower APR because it just doesn’t make good financial sense. Paying off a loan doesn’t increase your net worth by a single penny; it only ensures your net worth does not decrease! For the skeptics out there, I’ve provided an example.
On January 1st, 2024, Phil, Jill, Will and Kevin all receive a $20,000 inheritance and have to decide what to do with it. Each of them also has a $20,000 balance on a student loan at 5% APR with eight years left to pay the loan. The monthly payments on that loan are $253.20.
- Phil likes having the money, so he keeps it in his bank account and just makes minimum payments on the loan.
- Jill thinks all debt is bad and pays off the entire loan immediately.
- Will likes to invest, so he makes minimum payments on the loan and invests in safe stock market funds.
- Kevin likes to invest aggressively, so he makes minimum payments on the loan and invests very aggressively in his 401k.
In this hypothetical situation, here a chart of what each person’s account would look like at the end of the year, and the effective change on his or her net worth from the beginning of the year.
I’ll give all the details of how this information was calculated below, but the main thing I want to point out is that Jill’s net worth didn’t increase a single penny by paying off that loan. She went from having $20k in the bank to paying off $20k in debt. That, my friends, is what we call a net-zero transaction. She didn’t lose money, but she didn’t gain any either.
I can’t say it enough; rich people don’t get rich by avoiding debt. Very few business owners start a business with their own money. Almost all of them take out a loan, and the ones that are successful get a much larger return on that investment than the 11% or whatever interest they paid to borrow it.
If you want to be comfortable, I’d suggest you pay off all your loans immediately. If you want to be rich, I suggest you get a current copy of your credit report and score, pay off all your bad debt, keep your good debt, and make your money grow!
Now here’s the math behind the numbers, for those of you who are nerdy like me. Feel free to stop reading now if math makes your head hurt.
Phil likes to horde money in his checking account that returns no interest. Maybe he’s likes keeping it there for an emergency fund. He makes minimum payments on the student loans and leaves the rest in the bank. At the end of the year, he will have paid $2,085.75 in principal on the loan, and $952.63 in interest. The only good thing about this is that the $952.63 in student loan interest reduces his taxable income by that much. If he’s in the 25% tax bracket, then he will save $238.16 on his tax bill, for a net worth loss of $714.47
Jill thinks all debt is bad debt so she pays off her student loan. By paying off the entire loan, she avoided paying $952.63 in interest (if she had made minimum payments on the loan for a year). It appears her one-year ROI is $952.63/$20,000, or 4.76%. However, if she had kept the loan and paid interest on student loans, that interest would have reduced her taxable income and she would have saved $238.16 on her 2010 tax bill, just like Phil.
When you subtract that from her cost avoidance, her actual return is just $714.47/$20,000, for 3.57%. She paid off a 5% loan but only got an effective 3.57% return. That’s not very good if you ask me.
Will needs to make 12 payments on that loan of $253.20, so he puts $3,038.38 in his checking account to cover those payments. Will has an extra $16,961.62 to invest, and he puts it in the stock market and receives the 14% return the S&P 500 had in 2010, or $2,374.63. Will paid $95He 2.63 in interest on his student loan, but made $2,374.63 investing the difference and saved $238.16 on his taxes because of the student loan interest. His overall net gain was $1,660.15, or 8.3%.
Kevin had the same idea as Will, but invested much more aggressively in the market and got a 26.85% return in 2024. Using the same numbers as Will, except Kevin’s investing returned $4,554.19, his overall net gain was 22.77%.
Finally, I do understand that stock market returns are not guaranteed in the future. However, the past is any indication, it is very reasonable to believe you can get a return better than 3.57% in the market, which is what you’d get by paying off the student loan.
For More Great Thousandaire Articles
How You Can Become A Millionaire With No Money
Everything You Aways Wanted To Know About Decamillionaires
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.
There is no such thing as “good” debt. Debt is debt, even student loans. And to put yourself in the best financial position, you should be looking to eliminate any and all debt as fast as you can.
If you receive a $20,000 inheritance but also have $20,000 in student loans, it would make the most sense to pay off the debt so that you can become debt-free. If you are in debt, the #1 goal is to get yourself out of it. Period.
Then how do you explain the math above? 😉
I just don’t believe in carrying student loan debt, ESPECIALLY if you have the means to pay it off. It just doesn’t make sense, regardless of how much you can make by investing the money instead.
Of course, personal finance is different for everyone. Me, I wasn’t comfortable carrying student loan debt with me. Some people could be okay with it. It’s all up to you and you comfort level.
In my eyes, student loan debt = bad debt.
@ krystalatwork, true to that, talking from experience, i was paying 10% of my income to my student loan, now i finished paying it off, i have 10% of my income in my pocket, how lovely is that, the only way to saving money is eliminating your debt first,
“Those who don’t know about interest pay for it, those who know earn it”
Invest it instead! I had 20k in cash 10 years ago….I held on to in a CD for several years and used it for a downpayment on a home….BAD IDEA. If I had invested all 20k in GOLD I would have 80k enough to buy my home with NO mortgage.
Or you could have picked natural gas to invest in instead of gold, and your 20k could be worth 1k… hindsight is 20/20
And i bet your Not a rich man i suppose lol
What do you mean it doesn’t make sense? It makes perfect sense to take money to make more money and not worry about debt. You have grown up in a society that tells everyone that debt is a bad thing to have because interest payments are evil. You have to pay to play and if you can beat the system by all means do it.
You forgot about capitol gains tax
It all depends on what the market does. In good years, paying off your student loans early will not be as beneficial as investing. In bad years, I’m sure many people had wished their investments that turned to dust were put towards their student loans instead.
In volatile times, I would rather have existing debt paid off first. Student loans are one of the few debts you cannot get rid of (even through bankruptcy most of the time!), and having the weight off that student loan off one’s shoulders and paid off completely is a liberating feeling for sure.
It’s funny you should post something like this today, my wife and I just decided this very same thing.
My student loans that just came out of grace 6 months age or now under the Income Based Repayment plan, that is to say based on my income and debt, our monthly payment is $1 for each loan, on average.
We actually do have some disposable income that we planned to throw at the debt but after considering other alternatives, what the debt was actually costing us and what options we could create with that other money, we decided to let the loans sit for a few years, pay the minimums, let the interest reduce our taxes and see how things look down the road.
I do hate having the debt, and if I was handed $20,000 I’d def put some of that money towards the debt, but like you said, there are other investments that could grow that money far faster than paying off that debt.
I’m with you. Sounds like we’ll both have student loans for a while longer. 🙂
Kevin, you are crazy. Crazy like a fox that is!
Your plan is good. You have a lot of time on your side and can always pay off the student loan later, just don’t lose money on the stock market. 🙂
Oh I’m sure I’ll lose some in the market, but I’m just hoping that I can make more than I lose!
I knew there was a reason I wasn’t paying off my student loans!
If you aren’t aggressively paying off student loans, make sure you’re investing extra money. If you aren’t investing extra money, then it is bad debt.
Considering the math above, and the stability (situation) of the individual, it would make more sense to hold on to a student loan rather than paying it off. I can also see the benefit of those, like Krystal, who would rather be rid of debt all together. I have to admit, I am with Krystal and would rather be truly debt-free, but this was a great read and you definitely made a valid point on why it makes sense to hold on to those student loans (at least for a while longer).
As long as you’re willing to take the risk, then it’s a great opportunity to increase your net worth. The best part is, it feels like you’re using other people’s money! 🙂
I had the same though years ago when my student loans came due to be paid. However, the market returned crap in the last 10 years and I’ve paid a shitload of interest on the debt that I now still have a significant balance on. Sometimes it works out, sometimes the market craps out.
That’s definitely a possibility. You have to be willing to take losses if you are going to play this game. I personally think the market still has a lot of rebounding to do, but if I’m wrong, this will backfire.
I was in the same position as Sandy. I graduated in 1999 with over $100K in student loans. I did the “smart” thing proposed by Kevin in the article and invested all my disposable income into the stock market.
Turns out 1999 was a real bad time to start investing in the market, and I lost a LOT of money over the next 10 years. Wish I had paid the loans off instead.
Bottom line: it’s not just about rate of return – you also have to factor in risk. With the “Kevin” strategy you are gambling that you will have a rate of return higher than your loan interest rate. That’s a pretty good bet – but as the “lost decade” shows us it’s not guaranteed. Paying off the loan is zero risk. Which one is the “right” choice? It’s a matter of your risk tolerance.
Risk is a huge factor that seems to have been omitted in this instance. It’s just as easy to make a 7% loss than it is to make a 7% return.
I have a very good deal on student loan – they are 0% interest. Yeps, you read that right – thanks to a special loan made by a nonprofit foundation, I don’t have to pay a penny in interest. There REALLY is no point for me to pay my loan back early.
Lucky.
See I don’t like the way you set this up. Then again, I like to disagree with people. 😛
You’re definitely betting a lot on the stock market. But you’re forgetting to take into account the fact that you have that minimum payment to make. Add in another minimum payment on a car loan, and the same with a mortgage (which both easily fit under 5% now), and pretty soon you’re paying out 50% of your income in minimum payments (because you put all your money in stocks). What happens when you start losing money? What do you have to fall back on? A bunch of debt.
This also only works if you receive enough money to pay off the debt entirely. Most people can’t say this. Without that initial lump sum to invest, rather than pay off the debt with, you don’t get that return from the market that wipes out the loss you take on the interest.
Sorry, but you didn’t convince me. I’m still gonna pay mine off next spring. 🙂
I didn’t forget the minimum payment. That’s why the people who are investing are only investing $16,961 instead of $20,000.
This principle also works if you don’t start with a $20,000 inheritance. It is just harder to demonstrate and I didn’t want to make the article longer.
The fact is, whether its $16,000 or $160, 14% is still better than 5%.
If you start losing money in your investments and you’ve lost your job, you can still pull that money out at a loss if you need to. That’s not ideal, but as long as your investments are reasonably safe, the money isn’t going to disappear.
It’s not “wrong” to pay off the debt as in it’s a bad idea. It’s just a safer choice with an upside that is capped very low.
Guess we’ll just have to agree to disagree on this one. 🙂
Ummm.. you’re just talking about a timing issue.
If you have $20K debt and 0 cash. Your net worth is -20K. If you suddenly get $20K that is used immediately to pay off your $20K in debt, your net worth RISES by 20K from -20K to 0.
It’s just accounting and semantics.
Pay off your loans! Unless of course all you have in the world is just cash equal to your loans!
Yes, net worth rose for everyone when they got the inheritance. I was showing their net worth one year later, which is where investing puts you ahead.
You never know whether investing puts you ahead or not. The ore cycles you see in investing, the more precarious things are.
Let’s say you just graduated college in 2008/2009 and started investing. You’ll be up most likely. But if you graduated in 2007 and started investing, who knows.
Also, if you earn more than $70,000 as a single filer, you can no longer deduct the interest, which is crap.
https://getcurrency.com/blog/does-the-u-s-steer-graduates-to-low-incomes
I agree investing is a risk, but at least it gives you a chance to increase your net worth. Paying off the whole loan immediately will guarantee that $20,000 won’t earn you a single penny in interest.
Income limits on student loan interest are dumb yes, so I guess there is more of a reason to pay them off if you are over that limit.
Whether or not someone can make more money investing their money than paying off loans is just one tiny part of the equation.
Having no loans FEELS better. It also means you can invest the amount you were using to pay off the loan in the future, so your net worth can in fact grow faster. Lastly, it is a guaranteed return that you don’t get in the stock market.
So yes, you could maybe make more by investing, but by paying of the loans, you are guaranteeing yourself a certain return, getting the debt monkey off your back, and freeing up cash for future use.
I’m in the “pay off your debt” camp. 🙂
I second this comment.
I third this comment 😉
And also want to make one important point. If as the previous comments says, you pay off the debt and begin investing the money that would have gone into debt repayment, you are effectively dollar-cost-averging into the stock market.
Otherwise, as the first commenter said, you are just “timing” the market. And as anyone who has studied the market and mutual funds out there know, that’s not a winning proposition.
If you dumped your $20K into an S&P 500 index fund (pretty conservative), on Wednesday, you just lost 5% by Friday. Not a great return for your one day in the market.
Dollar cost averaging is much safer, and is the natural by-product of being debt free and having cash flow to invest.
The best way to go, in my opinion.
Seems as though you stirred up a beehive with this one. 😉
The S&P 500 annual return in 2008 was -37.00%. Returns were also negative in 2000, 2001, 2002 and weakly positive in 2005 (paying the 5% interest on your student loan was a better bet).
Factor in that Stafford loans are more like 7% and then the S&P in 2007 would have been a bad bet as well.
This is to point out that you are rolling dice on the stock market and it all depends in what timeframe you are investing. Wall Street is a casino and yes, you can make money in a casino, but that doesn’t make it the correct investment for most people.
Paying off your student debt early is a guaranteed form of wealth creation that outperforms savings accounts, CDs, T-Bills, etc.
First, I agree there are ups and downs in the market. However, if you want to look at historical performance, then the market typically returns 8-9% over a long period of time. Yes, there will be years with negative or small growth, but there will also be years with a lot of growth.
On your other point, none of my Stafford loans are above 5%, but maybe I got a good deal. In fact, a few of mine are 2.47%. Especially when you account for the tax break on 2.47% loans, I can get a guaranteed investment that is better than paying those off.
Here are the current rates: http://www.staffordloan.com/stafford-loan-info/interest-rates.php. Only the undergrad subsidized rates are less than 5% and that is set to go up to 6.8% next year.
You also have to financially qualify for Stafford loans. If you don’t, the loan rate you get from a bank is worse (higher than 8%).
If your student loan rate is lower than the 30-year T-Bond rate (~4.25%) then it does not make sense to pay above the minimum on your student loans. Any rate higher than the T-Bond rate depends on your risk tolerance. You could invest in a startup and get 300% return by the logic of this article. But you will be eating a lot of risk along the way.
Nice job getting a 2.47% loan by the way. That is like found money when you factor in inflation!
I’m not really sure how I feel about this. While I don’t necessarily feel bad getting into student loan debt like some other bloggers, I’m sure if I had the means I would start hacking away at it and not investing it but thats just me. Good thing I have about two more years to decide my action plan. 🙂
The market may historically have higher returns but you forget that it’s extremely difficult to discharge student loans (almost impossible). If you carry students loans you’re one medical disaster, job loss, etc. away from financial ruin unless you have sufficient savings to cover the debt. Who’s to say tomorrow you won’t get into a car accident or lose your job? Yeah you may be making a little more money in the markets but you still have to make those loan repayments.
I have short term disability, long term disability, and medical insurance with enough money in my HSA to cover my annual maximum. The only one of those things that could potentially happen to ruin my finances would be losing my job, and I make sure that doesn’t happen by being a rock star.
Unexpected things can happen, but you can plan for them and mitigate risk.
I’m glad that you have things covered medically. May I ask if your coverage is through an employer? What happens if you, God forbid, get into a severe car accident and can’t work? Your medical is covered but you still need to spend part of your money on loan repayment if it’s determined you’re not in too desperate a situation. If you’re battling a medical crisis there’s no way you would want to use money repay something. If you can’t work because of medical reasons you could lose your job which in turn can lead to termination of medical coverage. At that point you may be able to discharge the loans but it’s because your life had reached a point where it’s going to be pretty grim financially.
Having said all that and trying not to sound too pessimistic, I agree with you that you can set aside some money for investments but not at the expense of not paying student loans off asap.
If that were to happen, I’d have 100% of my income for 3 months and then 60% of my income (and would not be taxed on it) after that thanks to my short and long term disability insurance. For any medical situation the makes me unable to work, I get paid by the insurance. The only way I’d be in trouble is if I lost my job, which is highly unlikely, and even if I did, I could get a new one pretty darn easily.
With that being said, not everyone has that much insurance and job security so it would be riskier for them to keep the loans.
That’s awesome. If someone were in your situation it probably is a better decision financially to invest than paying off loans quickly. But my point is still valid for the great majority of people with student loans: they don’t have that level of security so not paying off student loans is NOT the best option lest they risk being saddled with undischargeable debt if a crisis arise and are caught without adequate savings.
I agree the risk level is there, but the potential return is also there. I recently sold a call option for a 91% return after 3 months. I’ll take that over paying off student loans any day.
I think I’m a little late coming into this conversation. Great discussion for sure! I think that if Jill, Phil, and Will are in the exact same financial situation as Kevin, then yes…the math works. My guess is the logic would generally work for most people, but the emotions might not. This seems to be the most important comment reply: “If you aren’t aggressively paying off student loans, make sure you’re investing extra money. If you aren’t investing extra money, then it is bad debt.”
Thanks for the link back to the Carnival of PF!
This only works if the situation ends after the first year.. Which it does for the person who paid off all there debt.. the other people still have to deal with the debt payments the next year and the next year etc.. etc..
The returns on the investment continue year after year as well, assuming if you did invest at the beginning that you would keep the money invested instead of selling everything.
However, even if you did sell everything after 1 year, if you got the return on investment Will or Kevin had, then you could pay off the rest of the loan and still have money left over, whereas the person who paid of everything at the beginning of the year had nothing left over because it all went towards the debt.
This works forever, so long as the investment gets a better return than the debt.
I completely agree that investing in the market over paying off your low interest loans can make sense under the right conditions. I take issue with the way you convey investment in the market and specifically the risk associated with potential returns. You say that Kevin invests “more aggressively” which really means that he took on more risk, assuming an accurately priced market. It’s great that he made 26.85% return, but you can’t just fiat his success. It is as likely that he would have taken a loss or very small gain.
My understanding is that current Stafford loans are at 7% or higher. Paying on them is like investing and being guaranteed to earn 7% on your money as opposed hoping for a better return in the market at the risk of loss. A no hassle, no-risk 7% seems like the best choice for the the great majority of those with student loans.
However, I do believe that there could be better uses for the money than immediately paying the loan. If you currently rent in a large city for instance, then using the money for the down payment toward the purchase of an apartment could potentially make you much more than the 7%. If you were paying $1000 in rent prior to the inheritance, you could instead be paying $1000 towards your mortgage and gaining equity. You would be essentially paying your future self (neglecting the change of housing prices), as opposed to throwing that cash down the drain. Also, with housing prices about to rise (my bet), the value of your investment could go even higher!
You can’t find loans with under a 5 percent apr anymore. Most Federal loans are around 6-6.8 percent. Whats the likelyhood of getting a 6-7 percent return on an investment…
If you got a fixed rate loan, maybe. My variable rate loans are less than 3%. And I can’t say what the chances of getting a 7% return is in the future, but I got a 28% return last year.
Since I am going thru the same calculations for my wife’s student loans, I found this article interesting, but I do think there is a flaw in your calculations. For Phil, Will, and Kevin you give a relative increase in net worth from paying down the student loan with the minimum payments (in the form of decreasing the student loan balance), however, you don’t give equal consideration to Jill. Since she has paid off the loan on January 1, the money she would be putting towards the loan thru the rest of the year is instead free cash that serves to increase her net worth to the tune of $3,038.40 ($253.20 x 12) even if she just puts it under her mattress.
Add in the same 14% gain you gave to Will (compounding monthly) and turn the $253.20 into a monthly investment and it comes out as $3,241.15 at the end of the year.
She ends up only modestly behind Kevin in net worth, no debt with less aggressive investments.
Too bad I can’t erase a comment. I think I have already realized my mistake. In your example, no one is using regular income to pay the loan; it is all coming from the inheritance. Thus, all of the people could have the extra income to invest each month and get the same gain, thus, it becomes immaterial to the calculation.
I know that you have determined it can be better to keep your student loans and invest, however, I disagree that this is the best option for everyone. If you have massive student loan debt like I do, I would give anything to make them go away instantly. Because I’m stuck with student loans and cannot discharge the debt, I am constantly very nervous about my financial situation. The emotional burden of worry that are attached to my morgage-sized student loan debt is very stressful. If I ever came into a chunk of money, I would instantly pay down my loans, if only for the fact that it would help me sleep easier. Even if I could make more money by investing, the stress of having that much debt I cannot discharge is not worth holding on to. I advise every young person I talk to about college to not, under any circumstance, borrow large amounts of money to get an education. My so-called ‘good debt’ is preventing me from getting my own place to live, having health insurance, and eating three meals a day. My quality of life would increase exponentially if I could get rid of my loans right away. I think it may add a few years to my lifespan to do so as well!! 🙂
Don’t forget that Federally Guaranteed Student Loans are forgiven if you are permanantly disabled or die. Not a real pleasant thought, but it would really suck to pay back all of your student loans and then kick the bucket. Seriously, it’s like having an extra $60K of life insurance on myself.
Kevin,
I understand your strategy and the fact that you are extremely risk-tolerant, and I can agree with that. But just as a counterpoint, here are the numbers if you run the same experiment on 2008 (for just the triplets):
Phil: same (-$714.47)
Jill: same ($0.00)
Will: Instead of +14%, he gets -34%, and has $11,196 in investments, for a total of negative $6,479.93.
Again, you are correct about the earlier statement that over the long haul, the market will have good returns, and if you have the ability to out-perform the market (as you, er, Kevin did in this example), you should invest. But in the interest of full comparison, you should show that the investment strategy could backfire.
You’re wrong. Jill’s net worth did increase from -$20K (since that’s all the information you provided) to $0. That is an increase!
Kevin, I’m in accord with your thinking, yet most are not planful or disciplined enough to carry this approach out! For those who can stomach market volatility, stay invested for the long run, it is likely to be a financially lucrative strategy! nice job!
Nice approach for those with the discipline to carry it out. Need to be able to handle the volatility of the stock market. For the others, pay off the debt. Good article.
Hooray for this post! I recently got into a fight with another PF blogger when I advocated for “strategic debt” while he said that all debt is bad. This is a contentious issue, and I’m firmly on the “strategic debt” side!
Of course, the returns in the illustration aren’t — in my opinion — likely. Warren Buffet estimates that the long-term return in the U.S. market, going forward, is likely around 7 percent annualized, so I run most of my “what ifs?” under that assumption.
What none of this takes into account is the tax issue. Both Will and Kevin need to pay taxes on their capital gains from the stock market, and since it sounds like they sold within a year of purchasing the stock, this is at their regular tax rate of 25%.
So Will really gets $1,780.97 (not $2,374.63) for a true return of 5.3% instead of 8.3%
And Kevin really keeps only $3,415.64 after taxes (not $4,554.19), for a return of 13.5% instead of 22.77%.
And here’s another major problem. Look beyond the first year, and things start to seriously change. In year two, when Will and Kevin continue to pay $253.20 a month ($3,038 a year), Jill – who now has NO student loans at all – gets to pocket that money that she *would have spent* on the loans, effectively increasing her income by over $3,000 a year. Entirely risk free (i.e. without having to gamble 20 grand into the stock market), to get the same return as Kevin did in year 1. And she gets that every single year. Throw that cash into a 2% CD year in and year out after that first year, and you’re gonna catch up (and beat) Kevin in just a few years.
And this is fundamentally the problem with the posters logic. If we’re talking about playing for the long run, you have to look at a 3% loan as the alter ego negative shadow of a 4% stock gain (remember, 25% taxes; or whatever your personal tax rate is). Rather than building up your worth with a 4% (really 3%) gain, you are destroying a potential 3% loss (i.e. interest debt). It’s the same thing over the long run, except that if you have an 8% loan (like many do), you now need to make 10.66% in the market to match it. Best of luck with that.
.
Nobody is going to have consistent up years in the market. Nobody. The best hedge fund managers can maybe do it 8 out of 10 years, and we’re talking Soros and Buffett quality investors. Factor in how many hours and hours you’ll have to spend learning and reading to really be able to make consistent market gains, and it’s tough to make a strong case that it’s worth it. It is seriously like a second job at times, and it’s one of the reasons I gave it up and just focused on paying off loans instead.
The reality is, you’ll maybe beat the S&P by a few percentage points over the long haul (i.e. your entire lifetime) if you really know your stuff and put in the necessary time and effort to not lose a ton of money. But you may get massive swings in the meanwhile, and it really sucks to watch $20K turn into $16K in just a few months.
If you decide to pay off loans, you can consider each payment to be a risk free winning stock trade. The reason this is probably a wiser idea is that, if you have a 5% loan, you would need to be making *consistent* 6.66% winning stock picks (after your get taxed 25% on your winnings, a 6.66% win turns into a 5% actual take home gain). Not many people in this market can hit 6.66% average gains.
I will grant you that there is something to be said about having cash on hand if needed. If you pour every free dime into debt, you have no cash to buy things (downpayment on a house, trips, weddings, babies, etc). So don’t throw every dime at your debt, but it should probably take center stage for a while for a large part of your free money.
The best strategy, in my opinion, is to contribute what you can into a tax-advantaged account (Roth) and/or one that will lower your tax burden (401, SEP). Put it into low cost index funds, and diversify into several areas (large/mid/small cap, international, REIT, etc). This gives you a little skin in the game, and if it’s a 401 or SEP-IRA it also lowers your taxes (win-win). At the same time, pay off any debt above about 3% (again, it’s like a guaranteed 4% trade every time you make a payment). Also at the same time, put 5% of your earnings into a high yield savings account or CD (short term savings for those big events you need money for in your life). If you can aggressively pay down your debt, you can take any excess money you *were* putting into loans and throw it into the market. The interest your are NOT paying over a 30 year period will seriously increase your long term net worth. By a lot…
And again, I just need to emphasize that expecting consistent annual gains above about 5-6% nowadays is just ludicrous. Please keep in mind that the 7% average annual gain in the market that is often cited is over a 70 year period. Look at the S&P for the last decade, we are basically right where we started in October 2001. If you put $20,000 into the S&P on 10/10/01, you would today have…$20,000. Awesome.
It actually does take into account the tax issue. I mentioned that Kevin was investing in his 401k. And since the annual max is $15,500 in a 401k, he could put the rest in a Roth IRA. Both tax deferred accounts where capital gains aren’t taxed.
Also, you could invest outside of tax deferred accounts and hold for over a year so that money is only taxed 15% when you sell.
Or, you could buy and hold (I never said they sold anything) and let the money continue to grow without paying capital gains taxes.
Your analysis also ignores the tax benefits of paying student loan interest, which I highlighted above.
Your broad, sweeping generalization that you have to make 6.66% in the market to outweigh paying off 5% debt is only correct in the situation you described (comparing short term capital investments to non tax advantaged loans). However, if you read above, we are talking about student loans and 401k investing. I should have clarified the Roth IRA to catch the additional $5k, but other than that my analysis is sound.
You make a good point and provide a lot of good numbers. They just don’t apply in this situation.
Pro: Since the funds are guaranteed by the federal government, your credit report is not used in qualifying you for the loan. Con: Multiple borrowings — that means
you have to file and apply for a loan each academic year.
If you are paying 5% on the loan and you can invest the money in some way to get a greater return than 5% it can be profitable. This is the point that should be made in the article. You also have to look at the liquidity of the investments. A 401k is not very liquid nor are certain big purchases.
Kevin-
Thanks for the advice…
Will you update the chart with an example of “Kevin” that invested in the market in Jan 2011 (when you wrote the post) and had returns similar to that of the S&P?
How would that look? How would Jill’s return look in comparison?
~C
Great idea! I’m setting a reminder to post this at the very beginning of 2012 after the full year data is in. I will also see where the Kevin in 2010 is in relation to Jill. My guess is Jill would even be better off when Kevin gets the 27% in 2010. Such is the risk of investing.
I absolutely disagree. Net worth is just part of the equation. What’s more important is financial security and the notion that “a bird in hand is worth two in the bush.”
Debt is going to cost you X no matter what. It’s a liability. Less debt? More freedom. Less debt? More security. You can take a pay cut and be fine if you’re debt free.
Again, net worth is interesting, but it’s just part of the equation. Security and freedom are far more important to me — and that includes more than just when I’m 60.
I’ll say this coming from a Christian perspective, which some may choose to overlook (that’s fine): Debt is never a good thing. Not only is it irresponsible to hang onto debt when you could be free from it, and out of “slavery” to a creditor, it’s also foolish and risky. I completely respect the wisdom of this blog author. But, those numbers aren’t always the case. That’s a made up scheme that, to me, is not very true for most people. Average student loan debt is very high in our nation. To me, it’s bad enough that we have schools that encourage all of us (I’m only 25 and four years out of college) to get into debt, now we have people saying it’s good debt. It gets worse and worse. Also, your points about the “math” to me were very subjective (you can disagree). There’s probably a host of other variants, also realizing that most Americans are greedy and, if they have extra money, will simply waste it on something else they don’t need.
Unless you are a professional stockmarket broker, you won’t know how to make that much on your money. Most people simply put their money in a Money Market or Savings, which don’t even come CLOSE to 2% or 3%, which most loans generally soar above in their rates. So, how in the world keeping a student loan pays in the end is lost to me.
Don’t be greedy. If you have a family, don’t put them at risk. Just get rid of debt and THEN start investing.
Thanks for the article. And, sorry for respectfully disagreeing. 😉
Regularly payment of the debt is very hard, first pay the loan having high interest rate and then also pay the loan have low interest rate, write your debt on the spreadsheet and pay it regularly every month, if you will not pay your payment regularly the interest rate will be increased. Credit counseling is the best option but there is hundreds of scam companies search the best company in your area and be careful from scam companies.
Regards,
Jessey Ellen
Ya how is that “Aggressive investing” working out for you now? Boom goes the stock market dynamite and now you are down the interest from the loan and waiting for the market to go back up… oh no your car broke down… time to take out another loan!
Student Loans are the worst kind of debt anyone possibly have for the basic fact that they are NON-DISCHARGEABLE, except in very limited and exigent circumstances (i.e. death/dismemberment preventing you from working). Sure it can be deferred, but interest still accrues. Student loan rates are also sky high these days.
This is an interesting perspective that I hadn’t really considered! I’m going to have to take a look at my situation and assess whether this is for me. However, would you say that, given our economic standing, this math would still hold true?
Paid off all debt, lived within our means, and we’re happy campers, getting ready for the next economic slide in comfort. Don’t listen to foolish advice from investors who want you to inflate the bubble. We didn’t buy into the real estate bubble, and we’ve saved ourselves $100,000+ (!!) in lost equity based on 2009-2011 adjustments in our local housing market. Live within your means (AKA, not paycheck to paycheck!). It will make you happy. And then you can call up Clark Howard and gloat.
Wait, 3.57% return is NOT good in your eyes? What year was this article written? pre-2009? Spreads on commercial real estate don’t event yield that much. I think you just convinced me to pay off my student loans.
I have just about had it with SallieMafia.
In 1994 I took out a $12k loan to get my undergrad. Within a year I had to withdraw from school to get a job and care for my ailing wife. Needless to say, my loads went into forbearance and then default. I started paying the loan back in 2000, but by then it had ballooned to over $32k. I have been paying monthly ever since. Now my wife has advanced pancreatic and liver cancer from a rare genetic disease that we have recently discovered has been passed on to my 12 year old daughter. Medical bills continue to mount and medications are costing a bundle (with insurance). I have tried calling Salliemafia to talk with someone about loan forgiveness, but all they offer is lowering my payments which in the long run only increases debt, or hardship forbearance which only increases my debt. I have already paid over $17k in interest and have not even began to touch the principle. If I stop paying they will garnish my wages, if I file bankruptcy SallieMafia is protected and my loan will still exist. I am completely and totally screwed. I would much rather be spending the money to purchase medications for my family, or even deposit those dollars in an account for my daughters future education. I will never allow my daughter (assuming she lives long enough) to ever take out any student loans.. My advice to her will be to pay for college on credit cards and then file bankruptcy to wipe the loan..
David,
I’m so sorry to hear of your family’s illness. I will say a prayer for you all.
I’m with you about Sallie Mae and student loans in general.I am a teacher and I no longer, after my own experience with Sallie Mae, tell students to pay for college with loans. I think they should take an extra year or two and work their way through.
The investment option, especially the ‘aggressive’ investment option, could easily leave you with a substantial loss over a year and therefore leave you with both the original debt and the loss of a lot of your inheritance. The calculations above are not valid because it’s counting on you doing very well in investments, which is not something one should count on. Unfortunately, aggressive investment strategy does not equal financial gains. Sometimes it can be the case, but it’s not a sure thing by any means. Paying off debt, on the other hand, is a sure thing.
Instead of calling this thread “Don’t pay off your student loans,” it should be called “If you do well in the stock market, you will have more money than you did,” which of course is true but not very interesting a statement.
In general, I agree with your analysis. Two criticisms:
(1) Using the ROI for 2010 is wholly misleading. If you used the ROI for 2008 or 2009, Will and Kevin would look like idiots – particularly Kevin. You need to use an average of the market over the last say 10 years to have a more realistic basis for your example.
(2) Student debt is not dischargeable in bankruptcy. This changes the analysis quite severely when deciding whether to pay off the student loan debt. Although the student loan debt may have a lower interest rate, if you need to go bankrupt while pursuing risky ventures (which I’m assuming you’d suggest as most entreprenuers have done so), your student loan debt is a shackle around your neck.
Otherwise, good article.
This is all fine and dandy on paper, however what happens in year two? Jill has more of her income to invest, specifically $253.20 more/month, not to mention the money she’s saving in interest. Sure, those who invested money will earn a return on their investment (yay, compounding interest), and will likely be making more than the ~1.5% required to come out at a higher net gain than Jill, but you’re severely overstating the value of investing and understating the value of being debt free.
Again, on paper it makes sense to invest. Making it sound like “Gee, if I just pay my minimum payments, I could have $3839.72 more at the end of the year!” sounds alluring, but any money you’re investing suddenly is not fluid. When you pay off your debts, you can invest the money if it fits your lifestyle, but if suddenly your wife loses her job, you can take that money to pay your bills rather than having to scramble. You kind of covered this when talking about an emergency fund, but in the current economy, it’s not always realistic for older workers who lose their jobs to find a new one within 6 months or so.
No one is taking into account inflation. The REAL rate of inflation (if you calculate it how they use to – with gas, energy, and food prices) over the past 4 years has been roughly 9% a year. Given that fact, I have no problem sitting around with my 5% APR student loans. Paying $200 a month now, and paying $200 a month 5 years from now are two different things.
I’d rather invest and try to keep up with the rate of inflation.
I had 20k in student loans at 2.5% interest and I’ve been aggressively paying on them for 3 years. Currently, I have about 4k left that I will pay off entirely in the next six months. Personally, I hate having any debt so it’s worth it for me to get rid of it forever because once it’s gone, it’s gone forever. Besides, excessive amounts of money doesn’t make you happier unless you’re a shallow {bad word, edited by Kevin}.
Starting in 2013 interest on student loans can only be deducted for the first 60months of repayment. Therefore my wife, who graduated in 2006, will be beyond that 60month repayment term and that student loan interest will not help us come tax time. So my hope is to pay off all her student loans by March 2013!!
Wow, this is quite interesting. Are we also factoring the interest rates on the loans too in the calculations above? I am in a hurry to get my student loan paid off with some money producing assets!
Or you can do what I did. Keep the student loan debt, invest 20K in what you believe to be solid investments….and then lose it when the companies turn out to be crooks. Now you are left with 20K in debt and the 20K that you inheirited is gone as well. Now what?
You were taught a very valuable and very expensive lesson. You need to do your homework on the companies you invest in, pay attention to what they and their competitors are doing on a day-to-day basis, and ensure that you get out of them when you see bad signs. Don’t stick with a loser with the hopes that it will bounce back if there is no technical basis to believe that that is going to happen (and soon), because you can put that money into something more solid that will grow much faster.
Heres a better idea:
Use in-school deferments forever to keep outta default and never pay a dime.
I owe over 40,000 and havn’t paid a dime while keeping my credit good.
Enroll at a cheap community college part-time ($300 a semester for me), take online classes that interest you and do this forever until you die.
Number one rule: do not default on your student loans.
They have so many deferments and forbearances that you never have to pay these loans.
Don’t give dem crooks a dime.
If you have moral or ethical objections to this you had better educate yourself on how the banking and loan (especially student loans) systems are set up to entrap you in debt slavery.
.Play the system or it will play you.