For a couple of years when we first got married, we were on the fence about how aggressively we wanted to attack our low interest debt. Student loans are interesting because they’re generally low interest, but the asset you’re paying for really depends upon you on whether or not it will appreciate or depreciate over its lifetime. That asset? Your education. So we asked ourselves the question if we consider student loans good or bad debt?
Now that we’re a little older and a little wiser, we generally think all debt is bad debt unless it’s leveraged intelligently (we’ll get into that elsewhere regarding real estate investment). But there are some things to consider.
A good rule of thumb is that if you can get a greater return on your money than your interest rate on your loans, you’re better off over the long term investing your money.
This is a basic way of thinking about it, and involves some very simple math. There are circumstances that are more complex than this, of course, but I try to look at things as simply as possible.
If you have a mutual fund that historically returns 7%, and student loans clocking in at 4.5%, then it makes more sense to take extra income and pile it into that mutual fund for a total return of about 2.5%, rather than a total “loss” of 4.5%. Unless you’re sure you can get that 7% though, it might make sense to pay off the loans instead. Why?
Because you have a guaranteed 4.5% return on any part of your loans paid off early. If the interest rate is low enough, that guarantee may not be worth it in comparison to a potential 7%-11% in the market.
You should also consider the asset you purchased with your loans. In the case of a mortgage, that asset is a home. A mortgage with a low interest rate is often considered good debt because if the rate is low enough, it can be compensated for, or offset significantly, by the appreciation or build-up of equity in the home. This depends on the health of the housing market and a lot of other factors like the expenses of home-ownership, but it’s a good generalization of why mortgage debt (especially low interest debt) is considered a good debt — the interest on a home loan is also tax deductible.
Back to student loans, your asset is your education. If you have a valuable degree or valuable skills you learned in school, then it’s an asset that can appreciate just like a house. Your education can yield you a higher income or better jobs. If your degree is in underwater basketweaving though, you might rethink hanging onto those loans. Your job is less likely to return significantly, and in the end you’ll be paying a ton of interest on an essentially depreciating asset.
These are all things to consider when you are deciding how to attack your debt.
For a young person just getting out of school, you should also consider the most valuable asset in finance: time. Nothing is more critical to the accumulation of wealth than time. The earlier you can start making your money work for you, the more time it has to compound. If you spend all your extra income paying off low interest student loans so that you can feel good about being debt free, you miss out on several critical years worth of compounding and appreciation.
There’s a huge emotional aspect involved in being debt free. I think humans want that instant gratification — I know we did. We wanted to have the extra few hundred dollars a month in our bank accounts now, rather than think they might instead be tens of thousands of dollars in 20 years.
When we started off in our financial journey, we had decided not to pay off the student loans early. The interest rates were low enough, and the monthly payments were not so damaging that we could not afford a comfortable lifestyle (especially with two incomes). Instead we put extra income towards down payments on a house, paying off car debt, and so on. In other words, we built up for good debt, and paid off the bad debt.
None of our regular extra income went towards the student loans.
Our situation changed when we accumulated enough money from deployments and other savings to eliminate the loans all together. Rather than spending a few years paying extra, we cut them out of our lives within about 7 months. We netted an average 5% return on the interest and freed up almost $500 per month in investable income.
So while we sacrificed in the short term, the speed with which we paid them off and freed up other monies gave us a better foundation.
There’s no a clear-cut answer as to whether or not student loans are good debt.
All of the above things are things you should consider in prioritizing your debt.
Looking back in hindsight, we feel we made a smart decision. Both of our degrees were of the type that could maybe get us a foothold in an industry, but not much more as far as bargaining for salary. The remainder of our job success relied largely on performance and skill. We don’t see either of our degrees as tangible assets capable of appreciation; they served their purpose and warranted the initial expense to some degree, but were not worthy of additional interest.
What do you think about student loan debt? Pay it off or let it ride?
Edit: Student loan interest is also tax deductible