Student Loan debt is crippling the United States. It’s a $1.5 Trillion dollar crisis with over 44 million borrowers as Forbes recently reported. For those of you struggling with debt, this is not anything new. Many folks are fortunate enough to have family members pay for undergrad or even graduate school, but some aren’t as lucky. I took out almost $70K in undergraduate debt as a clueless, 18 year old. And about 10 years later, I took out another $120K in graduate school debt as a well-informed 29 year old embarking on an MBA.
I used to be obsessed with paying down debt, constantly anxious of the looming mountain I had over my head, but as I got older and more informed about financial principles, I felt this burden lighten, even as my debt mountain grew. I felt this way mostly because I realized debt isn’t debt, there’s good debt and bad debt.
There’s debt that is used to get something today that will create a greater return tomorrow – good debt – and debt that is used simply to buy things you can’t afford today – bad debt. I stared thinking about my financial position as one of a company and realized that, just as virtually all companies take on debt in order to grow, the same principal applies to my personal life. Student Loan debt was not just debt, but an investment in my professional development and would pay off in the long run by way of greater income and opportunities. Now, I’m not saying that all student debt is inherently “good”, but if you make a concerted effort to do a cost-benefit analysis and the results suggest that investing in education will pay off in some way, either financially or otherwise, then do it. Just make sure that you are going in “eyes wide open”. A PhD in an obscure field may not pay the bills, but if it gives you everlasting happiness, do it. If you’re just pursuing another graduate degree in some vain attempt to put off making a career decision, really understand that’s the price you’re paying and instead consider other, likely cheaper options, such as a gap year. The first step is being completely honest with yourself.
Okay, now that we’ve decided to make the plunge and did all the work associated with obtaining the degree, how do we manage this boatload of debt we are left with? First, refinance your loans into one payment to a lower interest rate, ideally one lower than your lowest current loan rate, if possible. I check rates about once a year to see if I qualify for any rate reductions. The purpose of this is to simplify the payment process (only one payment) and reduce the interest rate on your debt.
There are two main components of a refinance, the term of the loan and the rate of the loan. I, like many, used to be compulsively fixated on reducing the principle of the loan and reducing the term as that meant less total interest to be paid out. That is absolutely one metric to consider.
Alright, so why am I telling you all this? Well because during my latest refinance, I didn’t think of just reducing the rate and reducing the term of my loan (definitely a great way to think about it), but tried to think of a way to maximize the use of my post-tax income. I thought about extending my payment terms as a way to free up additional cash today to invest, because my cash today is worth more than my cash in one year. I wanted to see if it would make sense to do that. Here’s an example:
Current Scenario
- Current Student Loan Balance: $100,000
- Interest Rate: 5%
- Term: 10 Years
- Monthly Payment: $1,060.66
- Total Payments: $127,278.45
- Total Interest: $27,278.45
Okay, wow, that’s a lot of interest. Now let’s see about refinancing that to a super-low rate, say 2.5%.
Scenario 1
- Current Student Loan Balance: $100,000
- Interest Rate: 2.5%
- Term: 10 Years
- Monthly Payment: $942.70
- Total Payments: $113,123.87
- Total Interest: $13,123.87
So reducing the interest rate by 50% saves you about 50% in interest (~14K). Additionally it saves you some in monthly payment (~$118/month). That sounds like a really good deal! And it is! However, I want to offer you one other way to think about things. Let’s say we want to reduce our monthly payment even more because we want to take the excess and invest it in the market.
Scenario 2
- Current Student Loan Balance: $100,000
- Interest Rate: 2.5%
- Term: 15 Years
- Monthly Payment: $666.79
- Total Payments: $120,022.03
- Total Interest: $20,022.03
Okay, we are still better off than the first scenario, but not by much, just about ~7K less in overall interest. However, our monthly payment is reduced by $394 a month. Now this can be great for those that are strapped monthly or those who believe that they can get a return on that $394 that will have a greater positive impact than the initial scenario which saves you a total of ~$14K in interest. I had a theory that investing this additional $394/month will yield me returns that will offset the $14K of interest. Let’s check this math.
I assume that the average return I can get in the market is about 7%, this is a widely accepted return, explained in great depth here. Now, let’s set up our assumptions. First, we will invest $394 per month in a fund that will return 7% annually. Second, we will continue to do this for the full 15 years of the loan term. The result is a total yields of $113,127 (Invested capital or the total of the $394/month = $70,920, Simple Interest = $31,800, Compound Interest or interest on the interest = $10,407).
Now, let’s compare that to the scenario where we do not have than extra $394/month, but after 10 years, have $943/month to invest for 5 years (our loan is paid off after 10 years). That yields a total of $65,758 (Invested capital or the total of the $943/month = $56,580, Simple Interest = $8,538, Compound Interest or interest on the interest = $641).
So what’s the result? Scenario 2 yields about $47,369 more than Scenario 1. However, we also need to account for the increased interest paid in Scenario 2, about $7,000. After removing that additional interest, we are left with a net benefit of $40,369 with Scenario 2. I think this example is really great because it flies in the face of much of the conventional wisdom to just repay debt as quickly as possible. Leverage is a great tool when used correctly and, as this example shows, can be used to get a much greater return.
I just completed this exercise using First Republic’s Student Loan Refinance Program.
*Please note, there are a number of other criteria that you should consider before making a choice to refinance that will be covered in a later post.
**I used this calculator to calculate all of the return on investment details in our above examples.
Photo by Yannes Kiefer on Unsplash