In this post you will learn :
- When it makes sense to pay down your student debt
- What is debt? How does inflation affects debt and interest rates?
Let's say you finish college with a sizable debt (50000$ to 120000$) and you are wondering what you should do. You make about 70000$ and you've been working for 2 years and want to buy a house. Should you pay down your student debt? Let's look at the 2 extreme options. Of course, you can do a mix of the both in the middle.
- Option1 : Pay down debt aggressively
- Option2 : keep debt as long as you can.
But before making any decisions, step back and think about the big picture. When it comes to investing we need to reduce risk. The following steps can help you do so. I believe this applies to everyone and should be use a recipe. This blog focuses mostly on what do with step #5. However, there is no point trying to work on step #5 if you did not completed the first steps.
- 1: Create the 6 months (or 1 year) rainy-day fund.
- 2: Pay down all consumer debt (such as credit cards).
- 3: Fund your 401k. Try to maximize the contribution this year.
- 4: Pay down all high interest debts.
- 5: Invest to create wealth.
Let's review a bit the concept of debt. As you probably know, the interest is the premium you pay for borrowing money (conversely someone is giving you that money in exchange). The interest value is based on a few things :
- Inflation level
If you're the US government, then you're in theory able to borrow at the best interest rate. One reason is that the risk to lending to the US government is very small (means it will always pay back). In fact, it has always paid back since the country was founded. Currently, the 10-year T-Note hovers around 2%. This the interest the US government pays to borrow for 10years. Here is a breakdown the current price for this (as of Jan 3rd 2017):
- 0-6months : 0.5%
- 2 years : 1.17%
- 5 years : 1.85%
- 10 years : 2.36%
- 30 years : 2.96%
Looking at those rates, if you can get a similar rate (or even 2x that), then you should consider this being a very good rate. Let's call this a good debt for now. The reason we call this a good debt is because of inflation.
For the 4th quarter of 2017, that inflation was 1.7%. Inflation is the amount on which prices go up. Usually your debt is fixed, then inflation will "eat away" a part of your debt. If you look back at the rates from US government, they go higher the longer the duration to compensate for inflationary risk. In fact, lending money to the US government for 2 years is not such a great idea since the rate is equal to the inflation rate, meaning you will likely not make any money.
When you get a loan, the lender needs to calculate his risk of losing his money. Usually lenders are sane and need to make a decent return on their assets. I say usually, because there are some exceptions, such as the government trying to help students. If you want to understand risk, let's take a look at the extremes. On the low-side there is the US government. It is considered one of the lowest risk debt since the US has a lot of assets and it can always increase it's income (raise taxes) so the likelihood of getting paid back is nearly 100%. Another example, is mortgage on a house. The bank lending you the money to buy a house will likely get repaid especially if its asking for a 20% downpayment. If the house were to drop suddenly right after you purchase and decide to foreclose on the house, they would not lose money on the 1st 20% drop. It is a good exercise to ask yourself what risk does a loan has and try to put yourself in the shoes of the lender. Credit card debt has very high interest rate since there is a chance you will not repay back and it is not backed by any assets.
Once we understand what is a debt made of and why interest rate is set the way it is, then the next question is :
"Should I pay down my debt?"
I am in the camp that one of the best investment you can make is to pay down debt. I also think that debt can be very powerful way to create assets. It is usually a case-by-case. One thing that most people forget is that if the interest is not deductible, then it makes the interest rate higher since you need to make more money to pay for the taxes. If you have debt with 6% of interest (or 1000$/ per year of interest). If your marginal tax-rate is 40%, then you need to make 1428$ to pay that 1000$ in interest. This means the interest rate you need to pay after-tax is now ~8.5% instead of 6%. Student debt is not income deductible if your MAGI is less than 75000$ or your jointly filing income is less than 155000$. This salary of 75000$ can easily be reached if you live in the expensive part of the country with a job in tech/finance/healthcare. Some might say it is better to invest in the S&P 500, but the average returns are about 8% but the rolling 10year return for S&P can be anywhere between 0% and 15%. If you happen to pick the wrong 10 years with a recession, then you can expect very sub-par 10 year returns. Let's say for the sake of argument that the return is actually 8%. This amount is taxable and it is at 20% so your return is now down to 6.4%. And this return has "market" risk. No one can predict when the next recession will hit and it will. It is just a matter of when.
Let's take a look at 2 different situations:
- John, Engineer, 27 making 95000$ and having 60000$ in student loans at 6% for 15 years.
- Jessica, marketing professional , 28 making 70000$ and having 60000$ in student loans at 3% for 5 years.
John : High-earner, high interest rate:
- Pay down debt at 6%. You make 8.4 % assuming before-tax money. There is no risk. Every dollars will generate 8.4% before-tax.
- Invest in S&P and make 8% before-tax and 6.4% after tax. Every dollars will generate 8% before tax including market risk.
So looking it this way, paying down your debt is not such a bad investment.
Jessica : Medium-earner, low debt:
- Pay down debt at 3%. Every dollars generates 3% before tax (because her loan interest is tax deductible).
- Invest in S&P and make 8% before tax and 6.4% after tax. Every dollars will generate 8% before tax including market risk.
Her situation is not as clear-cut as the previous one. In this case if you believe you're in the upswing of the business cycle it might be interesting to invest in S&P for a few years and then pay back the debt. But if you're at the tailwind of the business cycle, your returns might go down and paying debt might still be a good safe solution.
I hope this will help you figure out what is best for you.
- What do you think? Am I missing something?
- What would you do in their situations?
- If you have student debt, what are you planning to do?
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