Paying student debt isn’t a race
Why you should consider only making the minimum payment on student debt every month.
Anyone with a BBA is familiar with the term opportunity cost. An opportunity cost is “the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.” Opportunity costs apply to the use of time and money. With money, it is choosing to buy one thing over another, invest instead of pay debt, or some other alternative. The simple concept is overlooked in real-world applications but plays an instrumental part in financials.
By electing to go to college you’ve already addressed one opportunity cost. You chose to invest time in yourself with anticipation that it would allow you to make more money, get a job you’re passionate about, or some other outcome. With that decision comes the financial impact of debt that has its own separate opportunity costs.
There are countless articles on how to pay off debt as fast as possible. They suggest making massive monthly payments — using all money not tied to essential costs — until you are debt-free so you can “avoid paying interest.”
The fundamentals of this approach are valuable — promoting minimal spending and budgeting. But, this is not the best approach financially. By making massive monthly payments you will be debt-free faster, but you forgo the opportunity to invest — ultimately leading to a lower return on your money.
It is best to only make the minimum payment on student debt, and invest any additional money in index funds.
You should only make the minimum payment on student loans, minimize expenses to essentials (i.e. rent, car, groceries), and invest the rest of your money in index funds, like VTSAX by Vanguard. This puts you in a better financial position than those who wait to invest until they are debt-free. Here’s why:
Interest gained from Index Funds often outweighs interest paid in student debt
It’s very possible to earn interest at a rate that outweighs what you pay in interest. This makes it more profitable to invest your money than to pay down debt.
For example, say there are two people who both people have $20,000 in student debt with a 4% interest rate, $250 minimum monthly payment and up to $1000 a month to put towards payments.
Person A uses the full $1000 a month to make student debt payments, attempting to eliminate debt as fast as possible. They would repay that loan in just 21 months and pay $733 in total interest, investing $0 during that time.
Alternatively, Person B only makes the $250 minimum monthly payment on the student loan. It takes them 94 months to pay off student debt and they pay $3,300 in interest. But, they take the leftover $750 a month and invest it in an index fund, like VTSAX, that averages a 7% interest rate. By doing so, they should expect to accrue $22,500 in interest over those 94 months. That interest would pay for the $3,300 in interest on the loan plus yield an extra $19,200.
Now, since Person A paid down their debt in only 21 months let’s say they invest the full $1000 for 73 months following while Person B is still making debt payments. In 73 months Person A would earn $17,000 in interest. This pays for their $733 in interest and nets them $16,200. A nearly $3000 deficit to that of Person B over the same period of time.
By investing WHILE you pay down debt versus after you pay it down you give your money more time to accrue dividends, and gain interest.
Interest on student loans is tax-deductible
If you’re still not sold and don’t like the idea of paying more in interest this section is for you. No matter what, up to $2,500 of interest paid on student loans annually is tax-deductible. If you’re unfamiliar with tax deductions they are items you subtract from your income before you calculate the amount of taxes you owe on it. In other words, they effectively let you pay less in taxes, or in many cases get money back as a tax refund. By doing this with student debt interest paid, it allows you to keep even more of the interest earned on investments, and effectively pay no interest on loans.
When you pay down student debt as fast as possible most of your payments are on the principal (which is a good thing, and will happen with minimum payments — just takes longer). Those payments quickly then become money you can’t invest or get back through a tax write-off, limiting what you can earn in interest.
The tax write-off allows you to pay almost no interest on your student debt. So you make more money from investment’s interest while still paying down debt, at effectively no lost opportunity.
There is legislation that COULD remove debt
This COULD be the biggest reason to slow down your debt repayment but is NOT something to rely on.
Putting politics aside and the impact on our economy as a whole; there is a proposed bill that would eliminate $10,000 of everyone’s student debt. I want to re-emphasize the COULD here. I’m never one to count on the government to bail me out, and you shouldn’t either. But, this is something to consider in the current climate of student debt.
Normally, a bill like this should have no impact on a debt repayment strategy; continue making minimum payments, invest what money is leftover, and write off interest paid. But, with student debt interest and payments frozen this is an opportunity to take the money you would be paying towards student debt and invest it in a low-risk index fund. Then wait to see if the bill gets passed.
If it is passed, you save $10,000 in debt and have a larger nest of money collecting interest. If it’s not passed, but the money you’ve been investing instead of paying debt, plus the interest it’s earned towards the student loan once payments begin again. Subsequently, increasing the amount you would pay by just blindly making payments. This requires some financial discipline but is a great chance to take advantage of government relief.
In summary, just because you can pay off debt quickly doesn’t mean you should. Instead, take basic financial principles; keep a tight budget with only essential costs, and minimum payment on student debt. Then put the majority of your money towards index funds. By investing in index funds while paying debt, leveraging tax deductions, and potential government relief you can make money while you pay off your debt.
DISCLAIMER: I am by no means a financial advisor, and am not claiming this to be financial advice. This is solely what I have speculated to be true in my life.
