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.
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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.
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.
If you can assume 25% on your investment yearly then of course you don’t pay. But that’s not realistic.
Long term the overall stockmarket makes something like 9-10% on average. So while your numbers are a bit crazy. It still makes financial sense not to pay. But, you very well could be behind for a while.
One other plus is there are provisions that can forgive your debt after something like 20 years of making payments. So if you owe enough compared to your income you might never have to pay.
The negative about student loan debt is it won’t be forgiven in bankruptcy. I owe enough that I’ll probably never pay more than my interest (600/month) and let it disappear in 17 years.
Horrible advice. As already mentioned you assume long term market gains for those investing, which obviously is probably not the case.Also, as already mentioned what about the following year? Assume Jill can now invest that $253.20 a month and she earns only 5% she still could have what a little over $3,100 by the end of the year and if she only invested that same total over the 8 years the others are paying off their loan she would have 30k. Maybe in years 5-8 she could afford to invest 353.20 a month or more.You could mess with the numbers all day but regardless should would come out with no debt and most likely money to spend possible on investing. You could make it work out where long term she makes more
I’m really late to the party. My thought in this is monthly cash flow. I can keep paying my minimum payments at 5%, or I can aggressively pay it off and have the extra cash each month to invest aggressively. This article is an opinion pure and simple, and let me reiterate it can pay off very nicely (or very poorly).
I personally am interested in “guaranteed” returns when possible, paying off a loan has a guaranteed decrease in interest payments each year, and the month after you pay it off you will have extra money to invest where you please.
i’m trying to understand more about this subject, can you explain it clearer?http://www.pagode2011.com
You’re definitely ignoring all the money for the next 10 years that Jill is not spending on her monthly loan payments. In fact, if the others are paying $952/year in interest, plus more for the principal, then Jill has a lot more money that she can do with as she pleases (invest, spend, hoard).
and what about when the interest rate is more like 6.5%? I’ve been making payments for almost 2years and have just gotten under the original amount of the loan! So ridiculous! The gov’t will bail out big companies, banks, people who have bought homes they can’t afford, but if you go to school to better yourself, in order to make a living , support the economy, and pay taxes, forget about it you are gonna pay back every damn cent! I’m gonna pay mine off so I don’t have to give SallieMafia (I like that name) any more of my money in interest. It also deters me from going back to school for any further education… God bless America.