Want to get rich? Don't pay off your student loans

http://money.cnn.com/2014/12/11/investing/dont-pay-off-your-student-loans/index.html?sr=QZshare

by prostoalex • 12 years ago

43 77 12 years ago

money.cnn.com

elliott34• 12 years ago

The psychological benefit of paying off my student loans early was immense. While mathematically illogical and not in my best interest, I sleep better at night knowing that if I wanted to drop everything I was doing and do something else, I wouldn't have to worry about loans hanging over my head.

HCIdivision17• 12 years ago

Precisely. Getting rid of that burden is staggeringly valuable in many non-monetary ways, so much so I'd say it's more than worth it. Put another way: how much would you pay to be able to take any job you wanted, anywhere? There's a lot of caveats if you've got to make at least $5-15k a year in take-home pay just to keep up with interest payments.

schimmy_changa• 12 years ago

Definitely agree - it would have been tough for me to quit my stable job on the east coast and come out to SF (to earn much, much more) had I not eliminated my debt. The freedom can help you earn more as it allows you to take opportunities that might otherwise not be available to you.

I wrote a blog post on this, actually: http://colinschimmelfing.com/blog/why-im-irrational-about-re...

tswartz• 12 years ago

Completely agree with your last point that being in debt keeps you from properly exploiting opportunities. I'm working on paying off my debt as quick as possible too.

btw great job on Clever...very interesting.

autokad2• 12 years ago

to each their own i guess. I myself would feel much better having 30,000$ in cash and 30,000$ in student debt than having 0$ either way. I know myself would be a lot more 'free' to do what I wanted more with the former than the later.

shawnee_• 12 years ago

One important concept that I came across was Opportunity Cost -- the notion of quantifying what you give up when you chose one option over another. I asked myself: Why am I rushing to pay off loans with 3% to 6% interest rates when the S&P has historically returned 11%?

This isn't quite the most sage advice. The opportunity cost of student loans is actually the interest that compounds over long periods of time. Making high student loan payments (as a large percent of your income) early on, and taking advantage of the maximum deductible portion of student loan interest can be smart. (http://www.irs.gov/taxtopics/tc456.html) But again, depends on how you "play" in the S&P.

endeavour• 12 years ago

What nonsense. The interest paid from the S&P is compounded as well if you reinvest.

alexchamberlain• 12 years ago

You need to account for the value of debt vs the value of investment. Most people would attribute a higher (negative) value to personal debt than personal investment.

closetnerd3• 12 years ago

What I enjoyed most was this recent ad by bank of america which says "student loans are a fact of life". So instead of object to these ridiculously high tuition fees, we should just accept debt as a fact of life.

brianwawok• 12 years ago

70%+ of Americans accept "a mortgage" as a fact of life, and don't stress out. Its either pay $600 to some guy to rent a house, or buy a house but pay a $600 mortgage. Overall this is not a terrible strategy, and mortgages are good for a lot of people...

Some high % of Americans think the same thing about a new car every 3-5 years. This is a little more insane as people could build a lot more wealth if they drive a car 10 years, and use the extra money to invest in wealth building.

So in a perverse sort of way, I see where this ad is coming from. My guess is with a house, you have a physical object. You can (usually) unload it and pay the loan back. The car is losing value fast, but you are in a similar boat. I guess student loans are an investment in your brain and not a thing, so people hate them more?

unreal374• 12 years ago

Getting a Masters of French History degree, with $100,000 in student debt, is what people object to. Nothing against French History, but paying $100,000 on a credit card to learn it is not "investment in your brain". Investment implies the potential for a profitable return.

gohrt3• 12 years ago

Your house provides value for 30, 50, 100 years (to you or whoever you sell it to). Do your student loans? They might, or they might not, but there are plenty of cases where they would not (degree programs that are not economically lucractive).

You might have 30 years of enjoyment from your art history degree even if you never get an art history career to pay the bills, which is fine, if you understand what you are buying.

Delmania• 12 years ago

It's not just the collateral, usually you make a profit when you sell your house.

closetnerd3• 12 years ago

I suppose you've purposefully neglected that tuition fees become artificially inflated due to a high credit society/economy?

Since 1985, cost of college has increased by about 500% [1].

1. http://www.washingtonpost.com/blogs/worldviews/wp/2014/10/29...

niels_olson• 12 years ago

This is really the primary issue. Universities are building, there have never been as many deans and administrative assistants, and banks are always happy to extend more debt paying more interest than t-notes. And it's all subsidized by the government. Three scams for the price of, well, 3 scams.

Raphmedia• 12 years ago

Or you know, you can pay off your loans, never borrow again, and live a free life that allows you to move whenever you want to wherever you want for as long as you want without caring. Sure, you can keep those debts and ignore them while making good money. What happens if things go sour and you can't make minimum payment anymore?

Pay off your debts, and avoid being in someone else's pocket for as long as you can.

ahallock• 12 years ago

What happens if things go sour and you can't make minimum payment anymore?

Keep paying using the money you've saved from investing. I mean, if you have no will power, aren't organized, can't save because you have a gambling problem, etc., paying off your student loans sooner might make sense.

unreal374• 12 years ago

So the stock market has a little correction, and he loses his job in the resulting recession (a la 2008). The debt doesn't go down, the minimum payments remain the same, and now he has no income and half of the investment amount he once did. He has to take what was his "emergency fund" and use it to pay debt.

Debt is an awful burden to carry around for years. It limits potential decisions. When things go wrong in life, and they do, the timing is never great. Do "future you" a favor and ditch debt when you can.

Source: life experience

bosco• 12 years ago

The issue is he is telling this story from 2009-today in a frothy market. Yes, historically markets have gone up 9.2% on average over the last 50 years in a balanced portfolio but what happens if he invests from 2003-2008. It's a little different story. It's hard to use long term data for a short term notion.

Going forward, we are in a different environment where 9% might not be the annual return. Interest rates are almost nothing and not going back to late 70's level in the foreseeable future.

simplemts• 12 years ago

I couldn't agree more. Has an investors returns been 10% or more since 2000? No, 2007, no?

This guy basically got lucky by having spare income to invest at the bottoms of a stock market. Hardly advice I would give anyone now, where investing now is closer to buying at the top of the market at 2007 than at the bottom of 2009.

Better advice, pay off your debt with the highest interest rates first, have an emergency fund, invest any extra income you have.

bigtunacan• 12 years ago

I'm sure some investors lost during that time and others made well over 10% during the same time periods.

I've always invested and paid minimums to student loans and mortgage. I also locked in student loans and mortgage at very low rates, plus the effective interest rate is lowered by the tax advantage.

I've been investing in low fee index funds, because I'm not a stock broker, since 2002 and I have averaged about 14% growth year over year. That is much higher than I expected, but even at a modest 6 or 7% annual growth I would still be well ahead of paying off my student loans and mortgage. I never carry a balance on higher interest forms of debt such as credit cards.

golergka• 12 years ago

I don't think that what he means. He doesn't say that you have invest in stock market; rather, at least investigate your options, instead of focusing solely on repaying the debt.

GIFtheory• 12 years ago

Inflation is another important factor. If the rate of inflation exceeds your debt's interest rate, for example, your debt is effectively shrinking over time just due to inflation. http://www.investopedia.com/terms/r/realinterestrate.asp

mkingston• 12 years ago

Similarly, if your government exempts income tax on your pension contributions, ~30% right now and "10%" p.a. is probably the best expected return you'll make.

Even better, if your employer matches pension contributions, 100% right now is just about unbeatable.

Of course if you don't believe your pension will be around for you when you retire, perhaps you might disagree.

carsongross• 12 years ago

But what if this happens?

http://finance.yahoo.com/echarts?s=%5En225+interactive

mafribe4• 12 years ago

One thing I don't understand why not more american students geo-arbitrage. There are plenty of countries in Europe where university education is much cheaper, or even free. OK, maybe the top-top US universities might be a tad better than elsewhere, but the difference is at best small, especially at undergraduate level. All universities use similar textbooks, especially in introductory courses. Moreover the single biggest factor in how much you learn at university is how much effort you put in. Want to learn more? Party less ...

That way you can graduate debt-free, and have international experience and network, and might even have picked up a new language.

If you absolutely have to have a brand-name degree from an American university, get a masters. Much quicker and easier to get in.

pilsetnieks• 12 years ago

There are plenty of countries in Europe where university education is much cheaper, or even free

It's generally only for citizens or, at best, EU residents. The same universities charge a lot more if you're not European. Though not as much as American universities, of course.

autokad2• 12 years ago

also I think its harder to get financial aid (but not sure on that)

dubfan• 12 years ago

Universities in Germany are free for everyone, besides the semester fee which is negligible. http://www.washingtonpost.com/blogs/worldviews/wp/2014/10/29...

rayiner3• 12 years ago

OK, maybe the top-top US universities might be a tad better than elsewhere

Foreign universities have zero name-recognition in the U.S. Maybe Oxford or Cambridge, and even those only among a certain set (and that set does not include everyone you may want to impress with your resume).

prostoalex2• 12 years ago

I've arbitraged by getting a bachelor's degree from a no-name university in Europe, and then getting a Master's from a recognized school.

Not saying it's possible for everyone to swing it, but resume-wise people pay attention only to last educational institution and last employer.

pizza• 12 years ago

Want to learn more? Party less ...

Or become a hedonistic autodidact!

rhino369• 12 years ago

While some schools will allow Americans to go to college for free or for only a little money, they aren't going to put them in a dorm, feed them, and give then other living expenses.

I'd imagine even with free tuition, I'd imagine Sweden is more expensive than going to your local state school. And you can't get US financial aid or loans for foreign school.

People always compare brand name American private schools with public school in other countries. But America has public schools.

You can do your first two years at community college for near free. You can live with your family, work part time at McD's and have more than enough money to pay for school. Even if you don't want to work, poor students can afford tuition with Pell Grants, and middle class students can cover it with Stafford Loans.

Then do your last two years at a state school, which are often in cheap college towns. In a state like Illinois, you can do 2 years in community college, and then 2 year at UIUC--a world class university--for only like 30k in tuition for the whole 4 years.

It wouldn't surprise me if going to Sweden cost 30k more in living expenses over that period, especially if you live with your family for the first 2 years.

mafribe4• 12 years ago

I'm not very familiar with community colleges in the US. If it's such a viable route, why don't more people go for it?

prostoalex2• 12 years ago

Or arbitrage by doing X years at a cheap local school, transferring credits and then spending 1 year at an expensive big-name school.

virtualwhys• 12 years ago

I just paid off the remainder of my loan today in one lump sum ($40K), enough was enough.

Taking into account the fixed 6.5% interest rate the government backed lender was happily reeling in, and my skeptism that the stock market can continue to rise against printing press backed economies, I thought, screw it, let's just get it over with.

Not sure what things are like outside the States, but within the easy-money-for-18-year-old-kids market, it's a serious racket -- I had little awareness at that age of what I was getting into, and only later did I realize that, hmmm, the bachelor's in literature and master's in psychology...were pretty much completely useless given my profession: computer programmer o_O

kasey_junk• 12 years ago

This is an example of borrowing money to invest it ie leverage. Leverage can be a very powerful multiplier for wealth accumulation, but it is just a big an amplifier for downside risk. Once you move into leveraged investing you need to be much more sophisticated about your risk management. For instance, it is trivially easy to see a situation that involves correlated risks. That is, a massive stock downturn which causes the author to lose their job. They are then stuck not just with their paper losses (remember that they haven't made any profit yet) but they also do not have the ability to pay off their debt.

fludlight• 12 years ago

Depends on your timeframe. The S&P returned -22% from 1/1/2000 to 1/1/2010, and only +43% from 1/1/2000 to today. The annualized return is nowhere near the 11% quoted in the article.

ConnorBoyd• 12 years ago

11% might be the long-term historical average (last 75 years or so), but that still sounds pretty high.

YourCupOTea• 12 years ago

You aren't including dividend reinvestment and you are looking at the wrong time frame for the quoted percentage.

-5.65% from 1/2000 to 1/2010 with dividend reinvestment

+89.85% from 1/2000 to 12/2014 with dividend reinvestment

The annualized returns are generally over rolling 30 year periods. which 12/1984 to today is 8.79% without reinvestment or 11.32% with reinvestment of dividends.

http://dqydj.net/sp-500-return-calculator/

dragontamer6• 12 years ago

Dividends are taxed at your income btw. So these values only make sense inside a tax-advantaged account.

They'll be a bit lower once you factor in taxes, which can be a sizable chuck (especially because that tax difference "compounds" year over year in the reinvestment case)

nisse722• 12 years ago

Exactly. Timing is everything:

http://www.nytimes.com/interactive/2011/01/02/business/20110...

dragontamer6• 12 years ago

Except you don't know if the stock market is going to go up 20% (as per 2009 through today), or go down by 20% (as per 2007 or 2000).

Paying off your debts is reliable. Gambling your borrowed money on the stock market seems like poor advice in general, even if the historical average works out.

You gotta plan for the worst, and in the worst case, your money is worth half of what you put in two or three years from now AND you got a massive student loan burden.

rbcgerard• 12 years ago

I'm not too impressed with the author's logic, but I think that if you have federally subsidized student loans (i.e. low interest rates) not paying down your loans is a good idea.

The reason is that net worth and liquidity are two very different things. I'd much rather have $20k in a checking account and a $40k student loan balance with a $500 monthly payment then a $20k student loan balance and a $500 monthly payment.

Secondly, given the that potentially some of the interest is deductible, and that the term on a student loan can be 10-25 years you can ~breakeven in the fixed income markets investing in bonds as opposed to paying down your student loan (or you can keep the maturity of those investments shorter, have a moderately negative carry, and be short interest rates)

porter• 12 years ago

Sure, if you can invest your excess cash into the stock market and earn more than your interest rate on your debt, it's a net win. The problem is that he is ignoring his downside. On a risk-adjusted basis he made a poor decision, which he'll probably discover if the stock market crashes again and he loses his job.

domdip• 12 years ago

I don't know of any competent financial planner that would seriously advise hanging onto debt at 6% and investing that money in equities. Even if this turns out to be a good idea in retrospect, it's terribly risky.

evanr• 12 years ago

What a great article on survivorship bias!

I guess the articles from graduate investors from 2008 didn't seem to make it past the editor.

acconrad• 12 years ago

While the advice that you should pursue financial opportunities with higher yields (10% stock returns over 6% student debt interest rates), it is certainly not that simple.

10% RoR is extremely optimistic, especially given that we are already in an optimistic, overpriced bull market that will not last (there are always corrections).

In addition, this 10% is on the S&P, so you'd have to assume that you only put money into an S&P fund and not any individual stocks, bonds or secondary securities. Those funds have management fees, so that too eats away at your yield.

But perhaps what is most important, is that plenty of people did quite poorly this year (the average return it appears was around 4.5% this year) so his assumptions are heavily weighted on speculation, volatility, and unproven performance.

sailfast• 12 years ago

I can't agree more with this comment. 10% return is insane to expect in the current market, especially since there is no actual safe haven that will get you any reliable return above inflation.

The fact that the author was overpaying because "he didn't like debt" tells me a lot about his financial expertise to start. That aside, of course go with the higher return stuff, contribute to your 401K for your company at the max instead of pushing it toward student loans, but the rest of the logic is somewhat baffling given any sort of perspective on the market.

I keep going back to the "Turkey that doesn't know tomorrow is Thanksgiving" analogy on this. Must be bliss to have such a short memory.

cpfohl• 12 years ago

If you're investing in an index fund against the S&P you're more or less going to track the stock market, which (historically) has been at or around 7-11%. This is not 'unproven' since the S&P 500 (in its current form) was created in 1957. That's a lot of years of data.

An index fund (as a rule) has extremely low fees. See Vanguard.com for an example. If you have more than $10k in a Vanguard index fund your fees will be .05%.

If you're thinking about how you did this year you're thinking wrong: stocks are a long term investment, not a get rich quick scheme.

rayiner3• 12 years ago

One wrinkle people are missing is that, for recent borrowers, the downside risk of not being able to make your minimum payment is eliminated. You never owe more than 10% of your disposable income for your federal student loans, and anything you don't pay off in 20 years is forgiven.

s_baby3• 12 years ago

I believe anything forgiven is counted as income. So you're going to be hit with a huge tax bill 25 years later.

rayiner3• 12 years ago

It's not clear how that will be handled, and in any case, because unpaid interest is not compounding, it's not as big of a tax bill as you might think.

ochoseis• 12 years ago

The way I see this is, the interest rate on your loans is like a guaranteed negative, compounding return that erodes your net worth. So, by paying down loans with 6% interest, it's akin to putting your money somewhere with a guaranteed 6% return, which sounds more appealing than an uncertain 8% market return.

nisse722• 12 years ago

If you have to pay tax on your investment return but can't deduct the cost of your debt, then reducing the 6% debt is more akin to getting a guaranteed return of something like 9% (more or less, depending on tax rates where you live).

cplease• 12 years ago

To add to points others have raised here, student loans are almost impossible to discharge in bankruptcy and backed by the full range of government collection methods (withholding of tax refunds, automatic wage garnishment, etc.). The only comparables are tax debt, child support, and possibly criminal restitution. There's not much of a safety net with student loans. There's some income-based repayment and forbearance options, but you pay more over time with these, and they only generally apply to federal loans, not private. Likewise there's some forgiveness options, only for federal loans, not private, and only after you've been bled dry for decades in poverty. Marry someone who's not poor? Forget it.

Basically, if you want security, try to get rid of student loans. I built up home equity and am now rolling my loans into a mortgage. 3% interest rate is lower than any refi options, no worries about the rate going up, and if I ever go broke, then worst case scenario I lose the house and am debt free.

bko• 12 years ago

I think the author's advice is basically to take out a leveraged bet on the stock market.

Sure, that is simplifying it a bit. Obviously, the stock market doesn't return 10% every year on the dot.

He mentions this as an aside but it's very important to consider the time period he invested in. Below is the continuous return for S&P500 in a 4 year period:

End: 1848.36 (12/31/13) Start: 1115.1 (12/31/09) Return: 13%

End: 1426.19 (12/31/12) Start: 903.25 (12/31/08) Return: 11%

End: 1257.6 (12/30/11) Start: 1468.36 (12/31/07) Return: -4%

End: 1257.64 (12/31/10) Start: 1418.3 (12/29/06) Return: -3%

End: 1115.1 (12/31/09) Start: 1248.29 (12/30/05) Return: -3%

End: 903.25 (12/31/08) Start: 1211.92 (12/31/04) Return: -7%

End: 1468.36 (12/31/07) Start: 1111.92 (12/31/03) Return: 7%

End: 1418.3 (12/29/06) Start: 879.82 (12/31/02) Return: 12%

End: 1248.29 (12/30/05) Start: 1148.08 (12/31/01) Return: 2%

End: 1211.92 (12/31/04) Start: 1320.28 (12/29/00) Return: -2%

End: 1111.92 (12/31/03) Start: 1469.25 (12/31/99) Return: -7%

End: 879.82 (12/31/02) Start: 1229.23 (12/31/98) Return: -8%

End: 1148.08 (12/31/01) Start: 970.43 (12/31/97) Return: 4%

End: 1320.28 (12/29/00) Start: 740.74 (12/31/96) Return: 14%

Hardly the no-brainer the author makes it out to be. In fact, only half the returns were positive. Maybe it's unfair to consider a 4 year time period, although that is what the author states. The 10 year returns still don't look great.

End: 1848.36 (12/31/13) Start: 1111.92 (12/31/03) Return: 5%

End: 1426.19 (12/31/12) Start: 879.82 (12/31/02) Return: 5%

End: 1257.6 (12/30/11) Start: 1148.08 (12/31/01) Return: 1%

End: 1257.64 (12/31/10) Start: 1320.28 (12/29/00) Return: 0%

End: 1115.1 (12/31/09) Start: 1469.25 (12/31/99) Return: -3%

End: 903.25 (12/31/08) Start: 1229.23 (12/31/98) Return: -3%

End: 1468.36 (12/31/07) Start: 970.43 (12/31/97) Return: 4%

End: 1418.3 (12/29/06) Start: 740.74 (12/31/96) Return: 6%

End: 1248.29 (12/30/05) Start: 615.93 (12/29/95) Return: 7%

End: 1211.92 (12/31/04) Start: 459.27 (12/30/94) Return: 10%

End: 1111.92 (12/31/03) Start: 466.45 (12/31/93) Return: 9%

End: 879.82 (12/31/02) Start: 435.71 (12/31/92) Return: 7%

End: 1148.08 (12/31/01) Start: 417.09 (12/31/91) Return: 10%

End: 1320.28 (12/29/00) Start: 330.22 (12/31/90) Return: 14%

Picking stocks as the author alluded to will probably make the actual results much worse.

I think it's generally irresponsible to give one data point and an oversimplified statistic about average annual returns to financially vulnerable students. Especially considering that the authors approach would essentially be a levered bet. Tax implications aside, if you're paying 3-6% interest on your loans, paying them off is a guaranteed return. Compare that to the appropriate risk-free benchmarks and you'll see that it's definitely a smart decision to payoff the loans as soon as possible.

Few notes, returns calculated are continuous compounding although I don't think student loans are continuously compounded. Also, I chose year end dates for convenience, although I'm sure if you took other dates, your results would vary greatly (but that's sort of my point)

danielrpa• 12 years ago

"Genius". He essentially borrowed money to invest in the stock market... Hmm, that sounds familiar....

Want to get rich? Don't pay off your student loans

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