How to Pay Off Student Loans While Building Wealth

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Here's a piece courtesy of  Marotta Asset Management on how to pay off student debts while also building wealth:

The average college student graduates with almost $20,000 in student loans. While this is a daunting sum, it is still possible to build wealth even while paying off student debt. But earning the degree and paying for the degree require two different kinds of smarts. In fact, some students may be better off not taking their parents' advice on how to get out of debt. Unlike most types of debt, student loans are usually best when paid as slowly as possible.

Almost all debt is bad debt. But, there are two important exceptions to this rule: home mortgages and student loans. Diligent savers can use these types of debt to their advantage.

Students often assume the best thing to do is to pay off student loans as quickly as possible. The sooner you pay off your loans, the sooner you can start building wealth, or so the thinking goes. But, given the opportunity, which answer should you choose: A) Make extra principle payments on your loan each month, or B) Pay the minimum amount due and save and invest the difference?

The real answer is: it depends. However as a rule of thumb, the lower the interest rate on your loans, the better off you'll be just paying the minimum monthly payment and nothing more. Take the extra money you were going to pay on your loan and invest it instead.

The lower the rate of interest on your loan and the higher the average market return, the more it makes sense to invest your extra dollars instead of paying down on your loan. The difference between these two rates is known as the "spread." If market rate of return is 11% and the interest on your student loan is 4%, then, the "spread" is 7% (11% minus 5%).

Let's look at two examples. Jane and Joe each have $20,000 in student loans which are to be paid over 10 years at 4% interest. Joe pays his monthly payments of $202 plus $100 extra to retire his debt as quickly as possible. By paying making bigger payments, Joe is able to pay off his debt in just over 6 years. Now, with his debt out of the way, Joe invests the full $302 per month that he had been putting towards his debt. Ten years after graduating, Joe has paid off his school debt and his investments have grown to $16,728.

Jane decides to adopt a different loan repayment strategy. Instead of paying extra on her loans, Jane pays only the minimum amount of $202. She takes the extra $100 per month that she could have been paying toward her debt and invests it. She continues this simple plan for the full life of her loan. Because she makes no extra payments on her loan, she takes the full 10 years to pay off her loan. Now, ten years later, Jane's loan is finally paid. However, her investments have grown to $21,700, beating Joe's return by $4,972!

Jane has made more than Joe even though she only paid the minimum balance due on her loan. Instead of making extra payments as Joe did, she invested her money for a longer period of time. And even though Joe was able to retire his debt sooner than Jane, his big monthly investments were unable to catch up with Jane's early saving. Jane was able to boost her savings by starting early and harnessing the power of compounding interest. In the investing world, we call this principle the 'time-value' of money.

However, this model is not ideal for everyone facing student loans. The smaller the spread between your loan interest rate and the average market return, the less appealing this strategy becomes.

But, there is one additional reason students should consider paying just the minimum monthly payment on student loans. Student loan interest, like home mortgage interest, is tax deductible. By allowing you a tax deduction of up to $2,500 for student loan interest, Uncle Sam is, in effect, helping to subsidize the cost of your loan. The faster you pay down principle, the faster you lose your tax deduction, which is one more reason that paying just the minimum may be the best option. And, with the savings from your tax deduction, you have more money to invest at higher rates of return.

In order to benefit from this loan repayment strategy, you must save and invest your money. If you don't invest the extra money, you would have been better off putting your extra dollars toward the repayment of your loan. But before deciding on a loan repayment strategy that's right for you, be sure to take care of the basics of first.

• Learn about your loans. Many student loans allow for a 6-9 month grace period before loan repayment begins. During this time, your loans may be charged a lower rate of interest. Consider consolidating your loans and locking in your interest rate while your loans are at a lower rate. This may not only help keep the cost of borrowing lower, but it will mean you only have to write one check per month.

• Establish an emergency fund. You should have enough money in your emergency fund to cover three months of expenses. This money should be used only in the case of emergencies, and not for those late-night runs to Taco Bell.

• Pay off your credit card. It's estimated that college graduates carry an average of $2,500 in credit card debt. Most credit cards have very high interest costs. Be sure that you are not one of them. You cannot build wealth while paying 19% interest on your credit card purchases. Do not begin investing until you have an emergency fund and have eliminated your credit card debt.

• Sign up for free money. If you have just started a new job, check to see what type of retirement benefits your company offers. Many companies will match your contributions dollar-for-dollar up to a certain percent of your pay. In other words, you get free money if you invest in the company retirement plan. Make every effort to contribute enough to get the full match. By doing so, you are, in essence, receiving a 100% return on your money. And, don't assume you are too young to save for retirement. By saving now, and harnessing the power of compounding interest, you'll have enough to retire long before most of your friends. Remember the time-value of money!

• Contribute to a Roth IRA. Once you've built up an emergency fund, paid off your credit cards, and taken advantage of any free money available through your employer, make every effort to invest any remaining dollars in a Roth IRA. A Roth IRA is the ideal place to put those extra dollars you were otherwise going to apply to your student loan principle.

Building wealth takes time. By starting early, you'll be sure to make the grade.

Comments

[Edmund]

You can't just look at the spread without taking risks into account. Paying off your loan generates a guaranteed return, while investing the money does not guarantee anything.

There is also something else that I found out the hard way. Student loan interest is *phased out* at a certain income level. If you make a certain amount of money a year, you are not allowed to deduct your interest. Your student loan goes from being a "good debt" to a "bad debt".

[Minimum Wage]

"...check to see what type of retirement benefits your company offers."

Not only do I get personal finance information here, I also get humor and entertainment!

[db]

@FMF:

You are making a really important point here. As anxious as I am to kill my evil student loan (hefty albatross that it is), after a lot of pondering and number-crunching I've come to the conclusion that I need to simply calm down about it.

That doesn't mean I don't want to work on paying it off early! It does mean, however, that I've recognized the urgency of saving and that I cannot shortchange a savings plan so that I can pay the evil student loan back with the same sort of gazelle intensity as I've been paying off debt. If I did that, at 50 I'd be student loan free (yay!) but I'd also have no more than $1000 in savings and only a paltry amount in retirement savings.

So -- here's to focusing on maximizing my career potential and getting totally focused on saving now that I'm nearly done with paying off unsecured debt. Just for my own edification, I've even built in a small student loan payment accelerator by rounding up to the nearest hundred.

Make War on Debt!
DB

[DH]

I have very mixed feelings about this article. I think the key quote from the article is this: "The smaller the spread between your loan interest rate and the average market return, the less appealing this strategy (delay paying the loan) becomes."

In the example, the article states a market rate of return of 11% I think this is absurdly high. 8% may be more realistic, and perhaps 7% over the next decade is a safer bet. Also, student loan rates are often close to 7% now, depending on the loan type. That makes the spread close to zero. After doing my own analysis, I recently paid off a 7% student loan of mine, using money I could have invested (but after funding my 401K and IRA).

I think it is a mistake to automatically assume student loans are always "good debt". I think it depends on the interest rate, and how you plan to leverage the education to get higher future earnings.

[BPG]

Great article! I could not have stated it better myself. It is so important for people to understand interest rates and the "spread" between what you could earn on the market anf what your student loans are. My student loans are locked in at around 3.25%. I would have a hard time agreeing with anyone telling me that I should pay that off as soon as possible, when I can make a (virtually) risk-free 5.10% return in my Vanguard Prime Money Market account or hopefully around a 10% return in the market. However, taxes certainly have to be considered and will lower the returns you are making in the market by 20 to 30%.

[Brad]

I was glad to see this article! I have been struggling with this myself. My student loan is my last debt to pay off. In a way I don't want to have it around for 20 years (a realistic number if you do minimum payments), but also I want to be investing for retirement. I have come to the conclusion that I want to fully invested in retirement and then start paying down the student loan with any extra money beyond that. Just have to get my fiance on board now (she wants to pay it off as quickly as possible). Partly so that she can stay at home when we start having kids in a couple of years. She's debt free, as of last week.

[cami]

I can identify with almost all of the comments posted thus far. I, like DB, really want to kill the student debt but I wonder if I should be doing something else with the money since my rates are low, though not quite as low as BPG's, however I am in school now (again) so they are deferred (half the money isn't even accruing interest). As Edmund pointed out, there is a phaseout and it starts fairly low (around 50k) and the interest deduction ends if your income is in the mid-60's (these are the numbers for singles and they can change slightly from year to year). Plus there are the advantages being debt free: you can stay home with your kids, take a lower paying job, or go back to school with out having to get a deferment of forbearance, which just delays the inevitable.

[Anitra]

I have to agree with Edmund and Brad. My husband and I pay the minimum on the loans that are below 4% interest, but we're paying down the higher rates (our highest is around 7%). We're doing a little investing, but we want to have kids soon, so while we still have "extra" money, we're aiming to reduce our monthly minimums.

[Ciji]

Tho' I owe about $45K, I'm in no hurry to pay it. My student loan interest rate is at 2.87% (I consolidated at the right time). It is a positive line on my credit report, because I pay on time and it's been open for several years. My monthly payment is about 80 bucks. This allowed me room to pay off other debts that have a higher interest rate, like that 19% Discover card I got in college (I paid it off but kept it open to raise my score, too.)

If I were to pay the student loan off, the account would be closed and my score would go down because of the number of open lines of credit I have.

My mortgage broker doesn't care how much I owe Sallie Mae: what's important is how high my score is. Once I buy my house, I'll be more aggressive in paying off that debt. But for now, I don't mind dragging my feet.

[Edmund]

Obviously 2.87% is below the current risk-free rate and you shouldn't pay that off.

Compare everything with the risk-free rate :)

Also, don't forget that your gains in investing are (usually) taxed.
As an (incomplete) example: A graduate locked in at 5% student loan, considering a money market rate of 6%. If the person is in the 20% tax bracket, the real interest earned on the money market will be closer to 4.8%.

[SOK]

This is all great advice... but does it change based on how much is owed? I went to medical school and have close to $200,000 in student loans. Does the same apply to me? Would love some advice... details on my blog.

[Bman]

Your advice is wrong. It doesnt cover the amount Jane lost in extra interest by paying her loan off slower which is no doubt thousands( in the end joe payed thousands less by paying it quicker). She ended up paying a higher amount on the loan, that was not in yur calculations.

Also every month interest is charged on the amount balanace owed so if someone owes 19000, his interest is calculated on 19000, that is hard to beat by investing even if you are making 10 percent on 150 dollar monthly inmvestment. IE your investment total balance must be more then the amount you owe and are being charged interest on, to be actually earning money.

[Tony]

SOK: The calculations do take that into consideration. They both used the exact same amount of money to pay off loans and invest over 20 years. However, Jane ends up with more (she paid more in interest to student loans, but the she earned more interest on her investments than she paid).

All the advice I find on the internet has similar information as this. Unfortunately, it is useless in today's climate. I'm sick of hearing about people with rates locked in at 3%. That isn't even possible today; Stafford loans from my first year are variable somewhere in the 7% range, and the next years are locked in at 6.8%. Then I have the PLUS loan which is locked in at 8.5%. I'm glad all you were able to go to school super cheap because you were born a few years earlier than me. Basically I get screwed.

[DumbDebt]

You are an IDIOT! You're so freaking stupid you M-O-R-O-N. You end up paying MORE for a debt if you don't pay it off as quickly as possible you stupid freaking idiot! The faster you pay off a debt the more you have for cashflow to save. The interest will kill you. Stop spreading lies you freaking IDIOT! DEBT IS BAD!!!! THERE IS NO SUCH THING AS GOOD DEBT. THERE'S TOOOOOOO MUCH RISK IN DEBT.

[FMF]

Wow. Someone woke up on the wrong side of the bed this morning.

[anotherlostsoul]

Wow. I've got a whopping $100,000. I'm not scared though, cause in the long run, you can take all my money all my chances to do well, but they will never kill my will to live and be happy. I find sofas comfy anyways.

[Travis]

I disagree with this article completely, for reasons others have spoken. I have $80,000 in debt, my minimum payment at a combination of 3.5% and 6% interest (average of 5%) is $330 a month and that's just INTEREST. NOT PRINCIPAL.. Where in the 9 hells am I going to get a return of 300 a month.. $330 * 12 = 3960 in interest.

I am considering a graduated plan that pays nothing on principal for the first 8 years of the life of the debt so if I don't pay anything extra, and say I put $100 extra into savings for 8 years at a 2 % return on a typical savings account, if I'm really lucky, 8% on a 401 k account: I would be looking at spending 31680 just in interest. Without making any progress on my principal balance, while saving, If I'm really lucky a minimum of $9600 and maybe with interest raising that to between 15000 and 17000 (if 401k does really really really well all 8 years).

Let's see, 31680- minus a very optimistic number of 17000 = 15000 in negative gains. if I actually applied that 100 to my principal balance for 8 years: That would reduce my interest over time significantly and I would have paid down my loans by 9600 and reduced my interest for the remaining 16 years of the loan life.

Granted I'll be almost 60 when my student loans are paid off, but, hey, just in time for retirement right? ???? ARG!

[Rob]

PLEASE...Tell me where I can get an investment with a monthly return higher than the amount of interest I pay each month. Screw the loans, I would take 6 hours of classes at the community college, get a deferment & I would put all of my money into that & let it pay itself off!!! But realistically, that type of investment does not exist in our current market, otherwise everyone in the world would be rich. Pay the stupid loans off early. If you pay the minimum on a 20 year loan, you end up paying back nearly double the loan amount. And in todays economy, there is no investment that will return that amount.

[Poor]

This makes no sense to me at all. I will have about $50,000 in loans to pay back starting in about 8 months at 6.8% I believe.

Now, I currently have a job that pays well but I can't stand it. However, if I really do without any toys (like I have the rest of my life!) I can have this PAID OFF in 3-4 years and I can still eat and have things, just not that nice Audi I want.

Or, I can go the suggested route and I will be paying off student loans at 54 YEARS OLD, because I went to college later in life obviously.

Also, my degree is not going to make me 1/2 of the money I currently make until I get that "minimum 5 years experience" in my chosen field, so I'm going to simply do without nice cars for a few years and be debt free, which will allow me to be WORRY FREE and out of debt.

Anyone that thinks that paying almost double your loan by stretching it out over 10 or 20 years is insane in my opinion, but what do I know.

I'm paying off as fast as humanly possible, and I'll eat Top Ramen to do it!

[Meyflower]

Wow! Some of you have a much higher amount in student loans than I do. I only owe about 10k. I've been thinking about cashing out part of my 401k to pay it off... I need advice! I'm getting married this summer and would like to have as little debt as possible.

[jyn]

Medical Doctor in residence with $200,000 loan.
Unbelievable!!

[ProfessorLatina]

I was taught by my parents that student loans were a huge mistake. I opted for schools that gave me a nearly full scholarship for my undergrad and grad, ending up with around $5K in student loans total in 2005. Then I wanted to go back to school, lost out on some aid last minute, and sunk in several thousand in loans before deciding a full time job was smarter financially than a second master's degree.

My spouse accrued around $50k in debt by the end of grad school, for a variety of reasons (from going to expensive universities, to going out of state, or just not meeting financial aid deadlines).

Our combined debt (and a terrible economy) have left us in a position where we have made a decision to forego a house, new car, luxuries,vacations, in order to keep up with our loans (about $400 a month), bills, and keep money in the bank. We are expecting our first child this year, and we are still not sure how to balance medical bills, loans, and regular bills without dipping into savings.

I think the smartest things college students can do is to AVOID or minimize taking out loans altogether. It is easy to do. Students can opt for community college, in-state schools, work harder in high school to earn high grades and achievements, choose less expensive public universities, be REALISTIC in their post-graduate expectations, work while in college, and put off unnecessary expenses (like a car, living off-campus, spending too much socially, charging on credit cards, etc.).

I think being smart at the start of the game is the only thing that will prevent students from finding themselves stifled financially at the start of their lives and careers. And I think the student loan companies know this and work hard on sucking in inexperienced students. (article URL included)

My two cents and some change.

[AJ]

Feeling hopeless again. I have 5 times the national average in debt. There has to be a way to pay this down.

[FMF]

AJ --

I'm sorry to hear that. You simply need to increase your income and decrease your expenses as much as you can. Then put as much as possible against the debt. It will take time and effort, but you can do it if you stick with it.

[RLT]

I really like what Professor Latina said above!!!!!!!!!!!! That is exactly what I did when I went to grad school for my MBA. I could have gone to a fancier more expensive school, but I chose a local university with a good rep, excellent price tage, and lived with my parents while I attended. So instead of $65000 in loans, I only have $6500. After the economy tanked and my husband lost his job, I was ever so thankful we were not burdened with paying back huge student loan amounts. Something to think about . . .

[Pico]

I am also in the student loan boat, and have debated my own strategy to repayment. Although all the omments are good above, there seems to be some major points missing. First of all, the tax credit for carrying student loans, depending on where you are at with your income. the majority of college graduates will qualify for the credit for at least 10 years, until the income level reaches higher levels.

Lastly, comparing the percentage rate on student loans to average return rate sounds like a good idea. But there are many things to take into consideration on that. The first being is considering the money you add today into 401K will likely be in there for 30 plus years, depending on your age. With this said, most college graduates, being the age they are at should be investing in riskier stocks (I know it doesn't seem like a good idea most recent). But my 401K has averaged 9% return over the last 5 years. So the other thing to take into consideration is the longevity of that account.

[me]

First, the income tax deduction for student loan interest paid begins to get phased out at $60,000 income and is completely gone at $75,000. So, if you went and got that post grad degree which actually results in a semi-decent salary (in this day and age at least), you've lost some, if not all of your deduction. I paid over $10,000 in interest last year. The deduction is capped at something like $2,500 (so $7,500 lost there), and I made "so much" money (which isn't really a lot since my student loans amount to a mortgage payment) that it got partially phased out to about $1,600. To top it off, I only worked full time for 8 months last year, this year I will make enough to completely phase out my entire deduction. So, all in all I got a deduction of $1,600 for over $10,000 of interest paid last year.

As for the average college student leaving school with $20,000 in debt, you're crazy. While I got through undergrad with a scholarship, four years of law school (J.D. and LL.M) amassed over $200,000 of loans! Hence the reference to mortgage payments above (#1,200 per month for 25 years!).

Good debt? Not necessarily. In the end, I will have paid over $400,000 in student loans (principal plus interest) and only $1,600 in income tax deductions for student loan interest paid (unless I get fired or quit my job and take a lower paying one - of course, then I won't be able to pay my loan payments, so I won't have interest payments to deduct). Be wary.

[None ya]

This is a bit misleading - as a tax deduction. The terrible over reaching and taxing government does not award the tax deduction to those making over 68K/year. So those of you making at least 68,001 need to take that into account. No doubt - the government will continue to lower this salary until it is no longer a tax deduction at all....

[CSC]

Something they don't underscore--a student loan dies with you--it does not fall to your estate or your parents or your spouse to pay-off. This appears to be the only upside left to keeping the fed loan--a private loan will not work this way. So if you have the misfortune to leave this world with a student loan on the books--it will follow you into the grave....I know this is morbid--but the topic these days is morbid. Why don't they just allow people to refi a consolidated loan to get a lower interest rate...at one time there was discussion on this in Congress--guess they got their pay raises and healthcare and on-site childcare---so....

[Jeff]

@CSC: It only dies with you if your name is the only one on it. If you consolidated your loans with anyone else and die, then you've just saddled them with extra debt.

[anna]

I paid off 125,000 dollars in medical school debt in 6 years. I started paying while in residency. I lived in the ghetto, had no cable, no cell phone, no magazine subscriptions, drove an old car. I made sacrifices. My interest rates were 12.5% ad 8.9% and it was imperative that I pay them off. I did it and it feels wonderful. My income at the time was between 40-70,000 a year. Not a penny more.

[John]

I think this article is right on track and I have lived it. I had just barely enough in cash about 4 to 5 years ago to pay off my 50k in student loans I have left. After paying them off, I would have had maybe about 15k left to my name but been pretty much debt free accept for my home. However, I must have actually learned something in my MBA which of course is where all these loans generated from! I instead set up an agressive strategy for investing and did what the article stated but even in a more aggressive fashion. Well, long story short, and about a half million dollars later at this point, it has paid off big!

In my humble opinion with a financial background, I believe the following: pay them off as slow as possible as the article says. Even putting that money into your 401k is tax free and if you stretch it till your 65 you could pay them off tax free out of the 401k anyway! So now I am in a position where I am very financially secure based on what this article said above as a strategy. Obviously I could pay the loans off 10 times over at this point, but why would I? Plus, how many loans would give you a couple years of forbearance without ruining your credit? Zero outside of student loans. Save your money for a rainy day. If it comes, you can forebare your student loans for years without wrecking your credit and pay your other bills to stay afloat with what you have saved and invested not paid on your loans. So many angles on this, I will not write further on why you should stretch them out. Lets just say there are many angles I can think of further ontop of what is written in this article supporting why you would not pay them off immediately. Just my humble opinion, but should be a powerful one considering I have lived and prospered from the concepts in this article.

[TheGooch]

Any debt is risky, you lose your job and now it's due. By the time fees hit and your credit report reads like the who's who of the collection industry, your paltry investment gains will be gone as if they never existed.

Pay of your debt first, and don't make any new debts later.

[AMJ]

While I don't agree 100% with the article (generally because I am finicky and I hate that I have any debt whatsoever) it really did make me calm down a bit. I'm an agressive saver and because of it, my parents are handling 90% of my loans (totaling about $45k). They are really encouraging me to pay off my smallest loan at the minimum payment (now and on my own) and save, save, save for retirement, my emergency fund, investing and a home downpayment. So I really do appreciate this article; it reaffirms my strategy at least until I take over the rest of my loans in 5 years or so. Thanks.

[Tonya]

What about the EXTRA INTEREST Jane pays? That was not taken into account. 4% of extra interest over 4 years can be a hefty sum. I get the point trying to be made, but this isn't really all that accurate. They probably come out about even and Joe doesn't have to deal with the stress of taking 10 years to pay off student loans from college.

[Yaya_HK]

I know I better start mentally preparing myself now!!