Today’s topic is one that is near and dear to my wallet, as I’m sure it is with all of you. Student loans. Whether you’re graduating this spring, next semester, or have been out of school for a while now, student loans are a huge piece of your financial picture and likely something that keeps you up at night.
According to the Federal Reserve’s February 2018 Consumer Credit Report, student loan debt has now reached $1.49 trillion dollars in the U.S. That’s a staggering number.[1] To put that into perspective, the average the student graduates with $33,863 of loans and a monthly payment of $376.[2] Based on projected income for 2017 graduates, student loan payments account for roughly 9% gross income.[3]
Many people have strong emotions towards debt. Rightfully so! However, this can often lead them to make decisions emotionally, especially in the context of when and how much to start saving.
The strategy I hear the most is “I should pay back my loans as quickly as possible. Then once the debt is paid off, I’ll start saving.”
A second strategy I hear is “I want to stretch the payments out as long as possible and give myself some room.”
The good news is everything in finances can be verified with mathematics and economics. By taking emotions out of the equation, we can objectively understand the pros and cons of each. Try not to focus on the numbers, because the details are going to change depending on your specific situation. Rather, focus on the concept behind each example.
Let’s dive right in!
Strategy #1 – Pay off now save later
People take this approach to avoid paying more in interest, and it’s true. The longer you take to repay a loan, the more interest you’re going to pay. However, paying less interest does not mean you are going to have more MONEY all things considered.
Let’s look at a 30-year study period. In this example, Billy wants to make paying off debt a priority and chooses a 10-year repayment schedule. He has 50,000 in loans at a 6% interest rate, which comes out to a monthly payment of $534, or $6,408 annually. Because Billy is focused on paying off debt, he doesn’t have any money left over to save. For the first 10 years, all $6,408 goes towards paying off the loan.
Billy - Year 1
After which, Billy saves into an investment earning 6% interest for the last 20-years.[4]
Billy - Year 10
At the end of the 30-year study period, Billy has $249,827 and zero debt. Not too shabby!
But how does that compare to the alternative?
Strategy #2 – Pay Debt and Save Simultaneously
Susan choses a 30-year repayment option. Because she is spreading the loan over a longer period, her payment drops to roughly $285 per month, or $3,426 annually. This lower payment gives her the flexibility to save the difference of $2,982 ($6,408 - $3,426) starting day one. The money is put into the same investment earning 6% interest.
Susan - Year 1
Fast forward 10 years.
One day while going through the mail, Susan reads her statement from the student loan company. She still owes $41,676. “If only I would have chosen the 10-year repayment option, my loans gone! Instead, I still have a ton to go!”, she grumbles to herself in frustration. Susan pushes the statement aside and grabs a second envelope, this one from the investment company. She quickly scans to the bottom to check her balance. She has $41,663 in her account. An idea pops into her head, “Maybe I should cash in my investments to pay off my loans?”. After weighing her options, Susan decides to keep her investments and continue making her payments.
Susan - Year 10
At the end of the 30-year study period, Susan ends up with $249,827. The exact same amount of money as Billy!
How does this happen?
Billy repaid his loans in 10 years, which means he could only save for 20 years. Susan took 30 years to repay her loans but was also able to invest over the entire 30-year period.
People are taught that if they take longer to repay their loans, they’ll pay more in interest, and in turn have less money. However, if you save the difference between the two payments, you’ll end up in the exact same place (assuming your investments earn the same return as the interest rate on your loan).
The difference between the two examples is flexibility.
Life doesn’t always go according to plan. If something comes up in the first 10 years, whether it’s an unexpected medical bill or a business opportunity, Susan has access to cash. Billy, on the other hand, might be forced to put money on a credit card.
Billy has zero dollars in savings for the first 10 years. Susan, on the other hand, is saving $2,982 per yr growing at 6%.
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How does this apply to me?
You don’t need to be in such a hurry to pay off your student loans. If you’re a disciplined saver and invest the difference, extending your repayment shouldn’t cost you money in the long run. Instead, it will give you breathing room to start saving immediately, and cash on hand for both emergencies and opportunities.
Let me be clear. I’m am not suggesting that you take 30 years to pay off your loans. As your income rises, you’ll have more opportunities to attack debt. However, early on in your career, there are other things that should take priority over paying off debt, namely: protecting your income and saving the right amount of money.
Debt is an anchor that weighs down your ability to build wealth, but understanding when to pay off debt is just as important as not having it in the first place.
Stay savvy, my friends.
[1] 6% is a hypothetical rate of return and may or may not represent actual investment results. Past performance cannot predict future results.
[2] https://www.federalreserve.gov/releases/g19/current/default.htm
[3] Assuming a ten-year repayment schedule at 6% interest
[4] “Salaries for 2017 College Grads Hit All-Time High, Korn Ferry Analysis Shows”, Korn Ferry. https://www.kornferry.com/press/great-expectations-salaries-for-2017-college-grads-hit-all-time-high-korn-ferry-analysis-shows/
[5] 6% is a hypothetical rate of return and may or may not represent actual investment results. Past performance
cannot predict future results.
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