Finally. You’ve graduated college, accepted a new high paying job, and are ready to start paying down your student loan debt. For the last 4 years, these loans have been a weight on your shoulders. Your goal is to pay off your loans as quick as possible so you can live the rest of your life in peace; forgetting that they were ever a source of oppression during your college years.
Paying off your debt quickly may seem like the best option for everyone since you are avoiding paying extra interest, but that isn’t always the case. The question you have to ask yourself is “What are my dollars doing for me?”
For instance, say you have a 10-year $30,000 dollar loan with a 4% annual interest rate. You also just happen to have $30,000 in your checking account. One option would be to pay off your loan in full before any interest accrues. You’d be saving $6,448 by not paying any interest. Seems like a good deal right? But what happens if you decide to invest the $30,000 in a tax advantaged investment account that returns 6% annually and then make regular monthly payments on the loan? At the end of 10 years your account would have grown to $54,582! You’ve earned $24,582 minus the $6,448 interest payments on the loan. So, by not paying of your debt your total benefit is $18,134! You have tripled your savings!
This concept is not out of the ordinary. Businesses use debt and financial leverage to get the highest return on investment as possible. Professional investors will borrow money in order to invest it at a higher rate. It can be applied to many personal finance situations as well. If your after-tax interest earnings on investments are greater than your savings from paying off your debt early, then you should leverage that debt and avoid paying it off early. This holds true as long as you’re able to make required monthly payments on your debt.
One important thing to remember is that investment returns are not guaranteed. In the short term, stock market volatility can make returns difficult to predict, so leveraging short term debt might not be the best move. In the long term (10+ years), stock market returns have averaged around 7%. But with that, past performance does not indicate future performance. You do have the possibility of losing money while investing, so you need to account for your risk tolerance. The best case would be to speak with a Certified Financial Planner (CFP) on this issue.
It’s also great to realize that interest paid on student loans and mortgages may be tax deductible, so there are additional savings there. Taxes on earnings for investments you’ve held longer than a year may be taxed at a lower rate (sometimes even 0%). There are also tax advantaged retirement accounts.
To better illustrate this concept, here is an example:
Sallie Mae is a recent K-State graduate with $50,000 in total student loan debt. $30,000 of that is a Federal loan with a 4% interest rate and $20,000 is a private loan with a 15% interest rate. Both loans are for 10 years and are eligible for tax deductible interest. She has a full-time job and can easily afford the monthly payments. She has recently returned from a vacation to Vegas where she won $50,000 on her first spin on the slot machine. She has several options:
- Pay off the Federal loan
- Pay off the Private loan
- Invest in a tax advantage retirement account that earns 6% annually
- Any combination of the options listed above
Here is the outcome of 3 different decisions:
||Pay off all debt (15%, 4%)
||Invest it all (6%)
||Pay down high interest rate debt (15%), then invest the rest (6%)
|Interest payments avoided*
|*assuming monthly compounding
As you can see, Sallie had the greatest savings when she paid off her high interest rate debt first, then invested the rest, while she made required payments on her low interest rate debt for 10 years.
So maybe you weren’t as lucky as Sallie to win $50,000. But, maybe you do have room in your budget to put an extra $50 dollars a month towards something. Well, the good news is this concept applies to extra monthly payments as well!
If you’re curious to learn about how you can maximize your money, schedule an appointment with a peer counselor! You can schedule an appointment at www.k-state.edu/powercatfinancial/
Peer Counselor I