One question I get quite often is: "MDAS, is it worth it to make minimum payments on my student loans and invest the difference?"
The long answer requires a bit of flushing out, but the short answer is NO. It is basically never worth it. I can understand why some people think this makes sense. (because the cost of their student loans is only 4% in interest per year while they are potentially earning 7-10% on their investments) Why would they want to divert their attention away from investing to pay down debt?
It is both a mathematical question and an emotional one. Something I like to ask people that usually spins their logic around is this:
Would you mortgage a paid-for house at 4% interest to invest in the stock market?
Well? Would you? If you said YES! I WOULD LOVE TO ADD A MORTGAGE ONTO MY FREE-AND-CLEAR HOME! then you may be someone who would rather invest than pay off student loans. To a perfectly sane human being, they would NEVER take on unnecessary debt in their life and risk real assets that they own in cash for the possibility of making slightly more money in the future. It just does not make logical sense in 99.9999% of situations.
I never recommend anyone to keep debt in their life. Debt is like a parachute slowing you down on your path to financial freedom. When in debt, you have to make payments that suck life out of your precious monthly cashflow, siphoning little soldiers that could potentially be invested FREE AND CLEAR without the worry of having to pay anyone at the end of the month.
With student loans, the balances can get so large (I have friends with hundreds of thousands in debt) and it can be scary. But the only correct thing to do is ATTACK your debts with the absolute highest intensity that you can. Pay them down as fast as possible, and THEN you can start investing.
Why do I recommend this? Not just because doing anything "Half Way" is a surefire way of being mediocre. But if you really want to build wealth, you can't do it by "kinda" paying off debt and "kinda" investing. If you are in debt: PAY IT OFF. If you are not in debt: INVEST. It is that simple. (Not in debt? Interested in reading about my 3 steps to achieving financial independence? CLICK HERE!)
For a more mathematical answer (which I know some of you requested specifically), lets think of it this way:
Say you have 100K in student loans at 4% annual interest (with a 20 year amortization) and the potential to invest at an 8% average annual return.
Your student loans will be costing you about 7k in annual interest, principle paydown, any fees, etc., so the minimum payment will be about $600/month right out of college. Keep in mind, you are just getting started building your investment portfolio so it is starting at $0.
With an average job right out of college (60k pre-tax income, and 48k after tax income), you are pulling in about $4k/month disposable income. This means that 15% of your income is going to go to student loans. ($600 is 15% of $4,000)
IF YOU SAVED AND INVESTED EVERY SINGLE PENNY OF YOUR INCOME (the remaining $3,400) IT WOULD TAKE YOU OVER 2 YEARS TO BUILD A PORTFOLIO BIG ENOUGH TO "PROFIT" (where profit = investable assets bring in more dollars than the debt costs.) This is because you would need $90k+ bringing in 8% annual interest to pay off the $7k/yr cost of the student loans.
The only problem with this calculation is that it does not take into account the RISK that your investment will bring in exactly 8% or better. What if your investments underperform? Then you can't make payments on your student loans. (Big problem) The math shows that you basically need the same amount invested as your student loan balance for it to be potentially "profitable", and it really isn't worth it. Becuase that is the point that you start to BREAK EVEN and POTENTIALLY make a few bucks.
The whole point of paying down your debts is to:
By using those extra dollars from your income and paying down your debt in those two years rather than investing it, you guarantee yourself a minimum of 4% annual return (the cost of your debt that you are paying down) and when it is all paid off you are maximizing your potential to build wealth by being able to invest free and clear at 8%.
For an EVEN MORE in depth explanation on why you need basically the same balance invested ($90k) earning DOUBLE the interest (8%) per year to come out "ahead" in this scenario, it is because of the way loans "amortize". The technical definition of AMORTIZE is to: reduce or extinguish a debt by money regularly put aside towards the principle.
This means when you pay an "amortizing" loan, you are paying both principle AND interest in each and every payment. This is in contrast to an "interest only" loan where you pay just the interest for a specific period of time and then return the principle balance owed at the end of the loan term. Here are two distinct examples of amortizing and interest only loans:
Interest only: When a bond issuer sells a bond, they promise the lender regular INTEREST payments, and the lender understands that the full PRINCIPLE amount will be paid back at the maturity date. During the life of the bond, the issuer only pays interest to the lender in the form of coupon payments. They are on the hook for the full principle balance at the end of the bond's life.
Amortizing: When a borrower takes out a traditional 30-year fixed mortgage, there is no money due at the end of the 30 years. This is because the total value of interest and the total borrowed principle is paid TOGETHER over the loan term. So the total balance due is paid in full by the end of the 30 years.
This is why a student loan of 100k at 4% interest amortized over 20 years costs more than just the $4,000/year in interest. It is because the borrower is ALSO paying off the 100k balance slowly over time, not just the interest due. This is similar to a mortgage on your education.
For a good book on the topic of why paying down debt is the only fool proof way to start building long-term wealth, check out The Total Money Makeover: A Proven Plan for Financial Fitness by Dave Ramsey. Dave writes in a very matter of fact tone that uses common sense and basic math to illustrate how powerful paying down debt is to building wealth.
I will be happy if this post brings just one person to the realization that paying down debt before investing is the way to achieve financial independence most efficiently. If so, please let me know! I love to hear about how well you guys are doing.
If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!
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