Stay with me for a moment and explain to me what I think about whether you should invest or repay your student loans. You may find the appropriate analogy to understand how to address this fundamental question.
In college, my physical education class was playing dodgeball. At the time, I was heavier and I did not know my athletic abilities.
I have never been selected first when it comes to choosing teams. The first choices were inevitably the fastest, the most athletic and the most aggressive. When the whistle started, these youngsters ran towards the court and immediately started catching up with the other team with almost unthinking abandon.
They really shone by sneaking into the weakest links of the opposing team. However, because of their risky behavior, they often found themselves blinded even by the most modest player.
It left you with people like me. I was always on the defensive and hiding behind my back. Not necessarily because I was afraid of being touched (well, maybe a little), but because I was playing a more conservative style.
After the fall of the easy targets, it left me the person responsible for catching the bullets thrown at me. I was not fast, but I had coordination.
I have always found that the best teams have a healthy balance of hyper aggressive kids who are determined to get as many members out as possible and conservative players who might catch up well.
This diversification is important to build a resilient team and increase the likelihood of achieving the highest expected return. In the case of dodgeball, win.
The lesson I learned from dodgeball also applies to deciding what to include in your investment portfolio. You should seek to maximize your expected return by buying attractive stocks and paying off expensive student loans early.
In the dodgeball analogy, your super aggressive kids and your conservative players work better as a team. By allocating money, the actions and repayment of student loans can fit perfectly into the optimal and diversified portfolio.
Invest or repay a student loan? Watch the expected return
We are all striving to create wealth and increase our net worth, which is simply calculated as follows:
Assets – Liabilities = Net Worth / Have
As you can see, to increase your net worth, you need to increase your assets, decrease your liabilities, or a combination of both.
To build your net worth, the safest way is to make regular and meaningful contributions and maximize the expected return on your investments. By following this logic, when you decide to invest or repay your student loans earlier, you should consider the expected return after tax investment or after-tax interest rate of your student debt as a range of performance opportunities.. This also applies to all types of debt.
What do I mean by that? Take the following example: you can either invest in a low-cost passive index fund, a 10% return, or make additional payments on your student loan balance at a rate of 4.5%.
Suppose you pay more than € 2,500 a year in interest (maximum deduction of income tax allowed on eligible student loans). When calculating the effective interest rate, net of tax savings, you will get an expected return lower than 4.5%.
Similarly, with the passive index fund, you can get a price appreciation of 9% and a dividend of 1%. Both are taxable (dividend on receipt, shares for sale) and would reduce the expected return to your marginal tax rate or long-term capital gains rate. You should also consider the effects on inflation on this return. With this background, what choice should you make?
In a purely economic concern to maximize the expected return, 10%> 4.5%, you must choose to: invest in the index fund. However, this decision might not be so simple. Debt carries additional risk and not all are created equal.
Factors affecting your risk tolerance
Maximizing your contributions and the expected return is the rational and economical approach to investing your money. But when you have a heavy debt burden, it can be difficult to think rationally, because risk tolerance plays a role.
Risk tolerance, which corresponds to the degree of variability of the returns of an investment that an individual is willing to bear, depends on a number of factors. The main ones include:
1. Age – Your age and stage of life can determine the level of risk you can tolerate. If you are young with less to lose, you can assume more risk by investing. Similarly, if you are older and have more assets at risk, you want to preserve your wealth. In response, you can choose to hold more cash and fixed income investments without having a lot of debt.
2 income – Your disposable income, closely related to your age, plays a role (disposable income after paying living expenses). If you are young and invincible and on a high deductible health plan, you probably do not have many obligations besides rent, food, entertainment, and student loan repayment. You may earn less, but still have more disposable income than a slightly older man who is married and has children. Without dependents, you can have a higher risk tolerance and invest more aggressively instead of paying off your student loans. However, instead of paying off your student loans, you can also face the decision to repay a student loan or mortgage.
3 Time Horizon – The time you have to invest or repay your loans affects your risk tolerance. When you are young and you can afford to hold riskier assets, you have better earning potential by investing instead of reducing your debt. Also, federal student loans accumulate interest, they do not compound. This gives an advantage to invest again. There are also options other than full repayment of the balance. For example, some student loans are eligible for the Public Service Loan forgiveness (PSLF) program, discussed below.
4 Debt Amount – If the debt is very large relative to your income and seems heavy, you may prefer to pay it back faster. In the case where PSLF is not an option, you should probably spend more money on repayment of loans based on your risk tolerance.
Now that you know the risk tolerance factors, let’s explore options for dealing with debt.
The first option to consider is refinancing. If you can reduce the interest rate and reduce the total cost to repay, you should take this opportunity.
What are student loans?
Many companies turn to the student loan market. I suggest you check out Student Loan Hero’s website for loan options or contact credit unions with refinancing options. Since credit unions are not-for-profit, they can offer very competitive rates.
My wife and I used Student Loan Hero to find a lender who would refinance the first batch of his loans. She started paying after finishing medical school and had a big fall before our wedding. We facilitated the repayment by refinancing and lowering its rate by 200 basis points (from 6.5% to 4.5%).
Despite receiving a generous student loan tax deduction for interest paid, we still chose to repay the loans. We felt it was more important to pay off student loans and optimize our savings with our 401k and ARIs. These loans were manageable in relation to our revenues.
If your student debt is high (2 times or more than your annual income), you might consider another option, the FPFP. This program cancels the balance of your loan after making 120 monthly payments (10 years).
The IRS attributes another benefit to the program by not having the loan balance canceled as income. Thus, when the remaining balance is forgiven, it does not constitute a taxable event.
What are income-based repayment plans?
Income-based repayment plans base your monthly payment on your discretionary income or adjusted gross income. For PSLF, the amount is 10% of your annual discretionary income. Non-PSLF income-based repayment plans range from 20 to 25 years.
The table below presents the available income-based repayment plans. To estimate the loan repayment amount based on your income, use the Federal Student Aid website. refund calculator.
The source: Federal Student Aid website
Why should you invest in this scenario?
If you follow the PSLF program, you are encouraged to maximize pre-tax pension contributions. This means knowing how to save money and maximize your traditional 401 (k), Individual Retirement Account (IRA), and Health Savings Account (HSA) contributions. This reduces your discretionary income and the amount you will have to repay over 10 years.
You should not pay extra towards your debt under PSLF. According to the Federal Student Aid website:
“If you make a monthly payment in excess of the amount you are required to pay, you… can receive a credit for only one payment per month, regardless of the amount you pay… However, if you want to pay more than the monthly amount Required Payment Amount… You may be paid in advance and you can not receive credit for a qualifying PSLF payment for a month where no payment is due. “
Refinancing and canceling student loans are popular ways of dealing with student loans. Some critics denigrate student loans, but not all are bad. When used appropriately, student loans can provide an investment in itself that will yield income for years to come.
In relation: When is a health savings account and HDHP a bad idea?
Can you repay your student loans sooner?
Student loans can be good or bad. Taking heavy loans to pursue a low-paying career or ambition is not advisable. Attending community colleges and public universities in the state is often enough to provide the education you need.
Finding scholarships is always recommended. You can even try to find scholarships to pay off your student loans after graduation.
Some areas require a lot of formal education and very often, student loans are included in the package. Becoming a doctor or lawyer is not cheap, but if it’s done well, student loans can be manageable.
How long does it take to pay off a student loan?
These well-paying areas can leave you with huge debts, but they also allow you to pay off your student loans in 5 years or less. If you are really thrifty, you can even pay off your student loans while you study.
Although unlikely, it is possible. However, if you choose the right medical specialty, you may be able to pay off your student loans in one year.
The goal is to weigh the costs and benefits of education. You will find the most effective way to repay your student loans if your approach is diligent.
Repay student loans or invest?
When you decide to invest or repay a student loan, you should try to maximize the expected return while weighing your risk tolerance. Look at refinancing or PSLF if you have a heavy burden in relation to your income.
Building the optimal portfolio varies from person to person. Just like the hunter ball, you want to strike the right balance between risk and risk of headaches.