There are almost 50 million Americans facing student loan debt today with an average balance of ~$30,000. The prevailing millennial finance narrative fixates on these student loans and crippling tuition costs that seem to doom this generation to a life of poverty. But the reality of the student loan “crisis” is much more nuanced. Let’s talk about flipping the script and how you can build generational wealth despite carrying student loans.
My Student Loan Story
I graduated with tens of thousands of dollars in student loans. At the start of my career, I focused diligently on managing my money and generally understood that paying off debt was a prudent decision. Debt is BAD financial media and “experts” shout. We should pay it off as soon as possible to avoid excess interest payments, right?
Initially, I felt somewhat intimidated by student loans and compelled by these popular arguments. I heard that by paying it down ASAP, I could lock in the “guaranteed” returns that are coveted across the personal finance blogosphere.
I reached “Level 3” of my financial game and decided to take action. So I paid off almost all of my student loans in a few years. I paid aggressively. I beat the odds. Screw the student loan crisis, I had mastered personal finance. [Pause for applause.]
But here’s the rub. I wish I hadn’t paid them down so aggressively. In fact, if I could go back in time, and apply all of the knowledge that I have acquired since, I would’ve only paid down about half of my student loans by now.
I’ll never claim that I regret paying off student loans. This would be pompous and misguided. I will, however, make the case that I could have approached the process in a smarter way.
The Goal of this Post
student loan burden facing the country’s next generation.
My goal for this counterintuitive post is to cast some much-needed optimism (and the analysis to back up it up) into the gloomy environment facing young professionals with student loans. Yes, the aggregate debt figures are frightening, and college education costs are undoubtedly flirting with absurdity. Yet there has never been a better time to invest, create alternative income streams, start a company, or learn a new skill.
The laptop or phone in your hands right now gives you the power to do all of these things from your kitchen counter! With increased student loan education, I hope you’ll come to appreciate the vast opportunities and flexibility properly managed debt can create in your life. But before we explore my student loan philosophy more deeply, let’s cover the basics.
Types of Student Loans
Federal Student Loans
These loans are provided by the US government and typically structured with attractive terms and interest rates. A student qualifies for these loans by completing the Federal Application for Student Aid (FAFSA) each year. They allow flexible repayment plans and options for forbearance and forgiveness depending upon individual circumstances. There are unique options and programs for every situation, from nurses and teachers, to low income earners who prefer to pay down loans as a set proportion of their salary. The government even temporarily suspended payments and set interest rates at zero percent on most federal loans as part of its COVID 19 response.
Within the federal category, the most desirable type of student loans are subsidized. This essentially means the government covers interest payments on the loans throughout a student’s time in school and for six months following graduation. Conversely, unsubsidized loans accrue interest throughout a student’s tenure in school and the six months following graduation. While students don’t have to pay down these unsubsidized loans any sooner, the accrued interest is added to the loan balance when the repayment period begins.
Private Student Loans
Private student debt is a bit more of the Wild West. There are some great private loan companies and products out there. But some are…not so great. If you’re wading into the waters of private loans, get ready to do your homework.
These loans are supplied by various private companies rather than the government. Private lenders can provide a welcome solution for students who have exhausted their ability to borrow federally, but still need further aid to cover the cost of education. Since these lenders are in the loan business to generate profits, repayment structures and timelines tend to be more rigid.
While federal student loans have traditionally offered more attractive interest rates, this depends upon individual circumstances. Borrowers with strong credit and career trajectories (such as top MBA candidates) may find cheaper rates on the private market. Even undergraduates without established credit and work histories should monitor the private lending market. Many of these companies offer the ability to refinance / consolidate debt at lower rates after graduation.
I don’t typically advise refinancing federal debt with a private lender. Even if you secure marginal interest rate reductions, you sacrifice all the benefits and forgiveness programs associated with federal loans. While it may be tough to quantify these ancillary perks, they carry unquestionable valuable.
Of course, every situation is unique. If there is a massive discrepancy between rates, and you stand to save $25,000 in interest over the course of your repayment period, explore your full suite of options. I’m not stopping you! Just keep your head on a swivel out there.
Keep your head on a swivel out there, kid.
Your Student Loan Playbook
Okay, enough with the definitions. Here’s my philosophy. I’m not saying it’s the best or only approach. However, I do think it represents a rational action plan. Hopefully, it provides a refreshing dose of optimism and empowerment to borrowers who feel trapped by their student loans.
Strategy for Low Interest Student Loans
If you have federal student loans with low fixed-interest rates (sub 4-5% depending on your risk tolerance) I believe consciously choosing to carry these loans long term could be reasonable. For private loans, I think the rates need to be even lower (say sub 3% fixed) to consider strategically holding them.
I dislike the personal finance industry’s tendency to oversimplify and categorize everything as either “good debt” or “bad debt.” It ignores important nuance in many cases. But here, it’s hard to make a case that this is anything besides good debt. You’ve invested in a highly appreciating asset (yourself!) at an attractive low fixed rate. Additionally, you may be eligible for the modified repayment plans or relief that we referenced earlier with federal loans.
Notice that I said I’m comfortable with you consciously choosing to make minimum payments. The idea is not to scrape by with minimum payments on student loans, and blow money on a lavish lifestyle enabled by debt. Rather, the conscious choice involves investing the money you could have used to pay down debt in even more attractive ways.
A Different Plan for your Money
This begs the question, how else could you put that money to use? Here are some scenarios that illustrate the power of making calculated alternative decisions instead of maximizing debt paydown:
- You lose a job early in your career. Luckily, you prioritized building a larger emergency fund that could last you ten months instead of three. This added cushion allows you to avoid taking a new job out of desperation and settling for underemployment. As a young professional, this could radically improve your job satisfaction and income trajectory throughout your entire life
- You have a great retirement program at your company. You decide to leverage the power of time, compound interest, and tax benefits by investing consistently into diversified index funds that could return 7-8% annually over a long term horizon. This could generate a significantly greater return than you’d receive by paying down a 4% loan early
- Note: these are conservative figures. There are additional factors (reduction in taxable income, student loan interest write-offs, employer matches) that could boost your real investment returns even higher
- You find yourself in a dead-end job with low income potential. Instead of settling for mediocrity, you save money aggressively to fund investments in yourself (coding bootcamp, real estate investment books, membership in relevant industry networking organizations, etc.) Your investments open entirely new doors to generate substantial income that you never would have considered
This list isn’t exhaustive, but it demonstrates the value that preserving flexibility and optionality early in your career creates. These intangible benefits are too often overlooked in mainstream financial circles.
Sure, it would be ideal to do all of these things without the burden of student debt. But you shouldn’t let your student loans hold you back either.
Student Loan WARNING
I want to avoid people misconstruing my playbook above. This advice is only applicable for debt that is 1) low interest 2) classified as student loans. I am NOT telling you to go finance an S Class Mercedes and buy bottle service on a credit card every night.
Even within the realm of student loans, many times it makes most sense to pay them down as aggressively as possible. Here are a few scenarios where you should prioritize debt paydown:
- The loans carry high interest rates (your definition of “high” is a personal one but see my guidance above)
- You don’t trust yourself to use money that could have been allocated towards paying down debt in responsible alternative ways
- You can’t sleep at night knowing you have debt
- Your outstanding loan balance is massive
- Even with attractive interest rates, if you have high five to six figure debt, you’ll pay crazy amounts of interest over the course of your loans. This will financially demoralize you
Paying Down Student Loans is Never “Wrong”
You’ll never be wrong when you pay down debt. It can be an empowering experience. It’s tough to put a price on the benefits it could provide to both your mental and financial health. Mathematically, it is a guaranteed risk-free return on investment which is challenging to find anywhere else. Just realize that depending on your loan terms, there’s a decent chance that you aren’t making the financially optimal choice.
The point is not to claim that it’s wrong to pay off student loans early. It’s to reconsider the prevailing narrative and baggage that many automatically associate with student loans. Given how prevalent these loans are throughout our society, we might as well strive to view them as a tool for empowerment rather than a source of anxiety.
Some Student Loan Math Behind This Cheap Talk
If you’ve made it this far, I take it these debt / investment tradeoffs fascinate you as much as they fascinate me. Congrats! You’re on you way to becoming a personal finance nerd.
For you casual observers allergic to spreadsheets…all good. Feel free to skip ahead to the Key Takeaways section.
For those craving numbers and data to back up the theories we’ve discussed, here are a few illustrative examples:
Example 1 – Cash Windfall
Joe is 23 years old with $35,000 in student loans. Let’s say his loans are on a ten-year repayment plan and he will retire in 40 years.
He comes into a sudden windfall of $35,000. Maybe it’s a bonus. Maybe a scratch-off hits. Or perhaps he finds a Pokemon card under his bed from 15 years ago and puts it on eBay.
He can either invest it immediately in an index fund (Option 1) or pay off his student loans entirely and instead invest the monthly loan payments that he would have made into the market (Option 2).
You can see that with an expected market return sufficiently above his interest rates, Joe comes out way ahead in retirement with Option 1. The opposite holds true when interest rates exceed investment returns.
It’s also crucial to remember that Option 2 assumes Joe has the discipline, patience, and emotional willpower to invest every cent that he would’ve spent on student loans each month for 10 years. I’d venture to guess that most people don’t fit this criteria. Put another way, you’re more likely to avoid defaulting on your debt by making a minimum monthly payment than you are to invest consistently throughout market cycles and chaos in your personal life. If Joe were to skip any monthly investment contributions, Option 1 would produce even greater relative gains.
[Cash Snacks note: we consider “nominal” investment returns in this analysis because they are compared to interest rates that have not been inflation-adjusted. It could be plausible to increase nominal investment returns to 10%+ given a 40-year time horizon, but we employ more conservative assumptions here]
Example 2 – Accelerated Payoff vs. Normal Payoff
Now consider Kelly who’s not quite as lucky as Joe. There’s no magic windfall for Kelly, but she also has $35,000 in loans with a 4% interest rate. Her loans are similarly on a ten-year repayment schedule and she has a 40-year retirement horizon.
She diligently manages her money and has $1,700 leftover each month to pay down debt and / or invest every month until retirement. In this simplified example, we’ll say this $1,700 figure is constant across her 40 years until retirement. (Ignoring lifestyle creep, changes in COL, salary, etc.)
If she wants to pay off all debt in 2 years, she’d have to allocate almost every dollar ($1,520/mo) to debt. If she stretches payments over 10 years, she can invest much more while simultaneously paying down debt.
As you can see, Kelly ends up with a net worth that is almost 3% greater at retirement if she pays off loans over 10 years rather than rushing to pay them off in 2 years.
The larger the spread between Kelly’s investment returns and the interest on her debt, the more pronounced this difference becomes. As noted above, a double digit nominal investment return could certainly be justifiable over a 40-year horizon, but 9% is used here for conservatism.
While all of those net worth figures may look great on paper, keep a few things in mind. First, those numbers represent nominal dollars. This is 40 years in the future! Due to inflation, they will not carry the same purchasing power. Second, it’s a testament to power of consistency. Regardless of how quickly you pay down debt, you’ll likely retire comfortably if you invest in a passive index fund every month for 40 years! Third, if there’s an opportunity to increase your net worth by 3%…you should be jumping at it. Who cares that an alternate path would lead to fine results if you could do better.
Key Student Loan Takeaways
Once again, everyone’s situation is unique. There’s no universally correct approach to tackling student loans. I cannot stress this enough.
With that said, I hope you’re now able to more critically evaluate the student debt “crisis” plaguing our country. Managed properly, student loans can be a powerful tool to empower opportunity and creativity.
If you take one thing from this post, remember that building wealth and having student loans are not mutually exclusive. Create a plan, stay the course and you may find yourself in a better position than you ever thought possible.