Ah yes, student loans. Near and dear to many a millennial. We love them while in school but hate them once we start making a little money and have to pay them back. The crushing amount of debt many of us are faced with comes second only to President Trump, in terms of things we like to rant about, and rightfully so. According to the U.S. Bureau of Labor Statistics, the cost of college tuition, including fees, has increased by about 370% from 1990 to 2017. The same source also notes that based on their numbers, college tuition has increased at an average annual inflation rate of nearly 6% and that a $20,000 education in 1990 would cost about $94,000 today. Just for reference, the average annual inflation rate for the US economy over the same period was about 2.4% – less than half the rate of tuition! We won’t dig into the reasons why this is the case (possibly a topic for another post), but do know that your arguments are completely justified. Rather, in this article I want to talk about some of the things I hear people with large amounts of debt discussing – chief among them, paying off their student loans as quickly as possible.
If you’ve spent time reading the about me section, you know that I am fairly risk-averse. But there is a difference between being risk-averse, and just being afraid of taking risks. I think it is this fear of taking risks that leads many of us, myself included, to find comfort in paying off our loans as early as possible. Now, don’t get me wrong. Paying off $40,000, $30,000 or even $20,000 in just a few years, and on a recent graduate salary is a huge feat, and one you should be extremely proud of. But the bigger question you should consider is “how has this affected my overall net worth, both now and in the future?” Despite tuition being high, one of the things we have going for us is that interest rates are incredibly low due the global economic issues that affected so many between 2007 and 2008, and while corporations are taking advantage of this by borrowing money very inexpensively and investing in projects with significantly higher returns, many individuals are failing to take their lead. This isn’t to say that you should rush to your bank and take out a loan to finance that long shot business idea that you haven’t really thought through, nor should you finance that 10 bedroom house in the hills that your income doesn’t support. Neither of these is expected to generate a return higher than the interest you’ll pay on the loan. But in the case of student loans, we like to think of these as (at least historically) being high ROI projects that will benefit us and our families for the rest of our lives. Additionally, many of us already have these loans, so why not refinance and take advantage of the extremely low rates being offered by many of the banks?
To illustrate, let’s consider two scenarios. In each, the majority of the assumptions are the same: debt is $100,000, the interest rate is 2.6%, and there is a ten year repayment period. We’ll also assume that the individual has $25,000 annually to allocate across investing and paying off loans and that the average S&P 500 return will be 10% over the time period (I’ll attach the model to the end of the post so that you can play with the assumptions).
Scenario #1 Goal: Cut Repayment Time in Half (From 10 years to 5 years)
We’ve already discussed the driving assumptions (download the model below to input your own assumptions), but the key takeaway here is that in this scenario we have paid off our loans by the end of year 5, and at this point we have also generated a net worth (limited to investments and student debt) of about $21,000. A great start, by all accounts.
Scenario #2 Goal: Maximize Net Worth
In this scenario, you’ll notice that it takes us the full 10 years for us to repay our loan, but you’ll also note that by year 5 we have generated about $29,000 in net worth – about $8,000 more than under the first scenario when we were just aiming to pay down our loans as quickly as possible. You’ll also notice that under this scenario, by year 10 we have generated a net worth of about $215,000, compared to only about $186,000 under the first scenario.
The first point I want to make is that it isn’t the end of the world if you have been racing against the clock to pay down your student debt. In some cases, it would actually still make sense to pay down your debt more aggressively than it would to actually try saving more. For instance, you’ll notice that in 2015 the S&P 500 only generated an annual return of about 1.4%, which is below the interest rate we are being charged on our debt. I haven’t run the numbers on this but that probably would have been a good time to switch from investing to paying down debt. The key is to stay flexible.
Next, notice that regardless of your decision, you will end up in a great spot if you make a plan and stick to it. That said, making informed decisions now can have a huge impact down the road. Under the current assumptions, if we go out to later years the difference in net worth gets substantially bigger. In year 16 for instance, under scenario #1 we would have generated a net worth of about $523,000, which isn’t bad, but under the 10-year plan, we would have generated about $574,000 – about $50,000 more. That may be enough to purchase a nice gift for yourself once you reach the point where it makes more sense to spend than to save.
Finally, and perhaps most importantly have fun experimenting with different combinations. Paying off debt isn’t fun, but when you think about it from the other side, growing wealth should be exciting! Download the model, make hypothetical assumptions, and see where your financial journey will take you 10, 15 years into the future. If you’re reading this blog, you’re likely already ahead of the game, so relax and enjoy the ride.
*As always, this post is meant to get the community thinking about ways to better its financial life. Always consult the appropriate professionals before making any major financial decisions