All Things Financial Planning Blog

Don’t Pay-Off Your Student Loans

40 Comments


Give the “Kiddie Tax” a Time-OutIf you are like most professionals, you graduated with over $100,000 in student loans. While that debt may feel like a monkey on your back, it is well worth it. Unlike credit card debt which is used to fund consumption, your student loans financed your education and training, and was as an investment in your career. Not only that, but it was also like free money in a period when you weren’t earning any. Now you are earning money and one of the most commonly asked questions I get is “should I pay off my student loans?” The short answer is that it depends on whether you are making the decision emotionally or purely from a financial perspective. Here are some things to consider before paying down your student loan.

Money Loses Value

Inflation is the erosion of the value of the dollar over time. We have all heard someone say “I remember when a new car cost…” Inflation is the reason why it cost $5 to see a movie when you were 18, but now it costs $12; or why $100 just doesn’t seem to buy as much as it did 10 years ago. If your loan is on a fixed-rate, inflation is your friend. Your fixed loan payment does not change for the duration of the loan, but the value of that payment decreases over time. For example, if your current loan payment is $800 per month, in 10 years, the real cost of that loan payment would be equal to $595 assuming a 3 percent inflation (see calculation below). Hence the purchasing power of that $800 has declined in that 10 year period to just $595. If the rate of inflation is higher than your fixed interest rate, you are essentially coming out ahead every year.

History Doesn’t Lie

Most current home buyers would cringe at a 5 percent home loan, but it wasn’t that long ago that 8 percent was the average. In fact, in 1981, the average mortgage rate was 16.63 (www.freddiemac.com)! So historically speaking, interest rates are at all time lows. Interest rates on student loans are also at historical rates. No one knows if interest rates will ever reach double digits again, but markets do tend to revert to their historical mean. If you currently have a student loan with a very low fixed interest rate, it makes more economic sense to pay only the minimum payments because of the low fixes rate and because of inflation.

Your Emotions

For a variety of reasons, some people have an aversion to debt – maybe you grew up seeing your parent’s worry about debt, or maybe your grandparents who lived through the Great Depression influenced you. Whatever the reason, if you are emotionally debt adverse, then it makes sense for you to aggressively pay down your debt, even if it’s financially prudent to pay only the minimum. If you can’t sleep at night worrying about your student loans, then it’s probably wise to start paying down your debt early.

The conventional wisdom is to pay off debt as quickly as possible and that all debt is bad. But as illustrated above, there is such a thing as good debt and it doesn’t always make sense to pay it off early. Yes, credit cards are generally considered bad debt, but student loans are an investment in your future earnings potential and is deemed good debt. For those who approach student loans from a strictly financial perspective, now is not the time to pay-off your student loans.

Ara OghoorianAra Oghoorian, CFP®, CFA
Founder and President
ACap Asset Management
Los Angeles, CA

Author: Ara Oghoorian, CFA, CFP®

Ara Oghoorian, CFA, CFP®, is the founder and president of ACap Asset Management, Inc., a boutique wealth management firm located in Los Angeles, CA. ACap provides comprehensive investment management and financial planning services with a niche in advising physicians and medical professionals. Ara began his professional career 20 years ago at Wells Fargo Bank in Huntington Beach, CA piloting new supermarket banks. He then moved to San Francisco to obtain a degree in finance and worked full time at the Federal Reserve Bank. Ara spent nearly nine years there as a bank examiner where he audited U.S. banks, bank holding companies, and foreign institutions from Japan, Hong Kong, China, Korea, Taiwan, Philippines, United Kingdom and France. In 2005, Ara accepted a prestigious position with the US Department of the Treasury as the resident advisor to the Ministry of Finance and Economy in the Republic of Armenia. He was responsible for advising the top officials of the Republic of Armenia on how to transition from a centralized audit function to a decentralized system. Upon his return to the US, Ara worked for a wealth management firm in the Washington DC area advising and managing the personal wealth of CEOs from Fortune 500 companies. Ara has spent his entire career in finance and as a result, he has a firm grasp of financial markets, economics, and their interactions. He is a member of the CFA Institute, CFA Society of Los Angeles, Financial Planning Association of Los Angeles, NAPFA, and Toastmasters International. In addition to his work in finance, Ara also sits on the board of the World Children’s Transplant Fund where he also chairs the annual Global Partners’ Dinner. Ara is a frequent speaker at local medical schools, medical societies, professional organizations, and private businesses. He has a degree in finance from San Francisco State University, is a Commissioned Bank Examiner through the Federal Reserve Board of Governors, holds the Chartered Financial Analyst (CFA) designation, Certified Financial Planner designation, and holds the Series 65 license. Ara currently lives in Los Angeles with his wife and two sons.

40 thoughts on “Don’t Pay-Off Your Student Loans

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  4. While the inflation argument seems like sound logic when taken at face value, it does not address the other half of the student loan equation: total interest paid. There are several repayment options that can stretch payments out over the course of 20-30 years, and while that does make for a smaller loan payment, it also makes for an obscene amount of total interest paid over the course of a lifetime. So yes, while $800 will seem more like $595 in 10 years due to inflation, I would think that most fiscally responsible folks would hate to see their actual college loan investment almost double with interest by the time all is said and done. And besides, who really wants to be paying $800 a month for 20+ years?

    Additionally, too many ill-prepared students are taking out these loans because everyone is telling them it is “good debt.” While I fully support the notion that the student loan ROI is well worth the initial investment when it leads to gainful employment in the field, it needs to come with the disclaimer that 1) the degree program must be completed and 2) the student should be enrolled in a program that will lead to future earnings that are commensurate with the amount they are borrowing. The looming student loan debt bubble is the culmination of too many who buy into all this “good debt” hype, max out on loans, are unable to finish their programs, or borrow far beyond what their chosen field will ever allow them to pay back. This epidemic is far too critical and wide-spread to, in good conscience, advise non-repayment.

  5. This is very dangerous advice for many clients. This may work for loans taken out 10 years ago at 2%, but most student loans today are close to 6.9% interest. Paying them off is equivalent to getting a guaranteed return of 6.9%, which is higher than most advisors project stocks will return, much less what a risk-free investment can return today.

    I hope this was written to just get a spark out of other advisors, because if this is the advice being given to clients, I would be shocked.

  6. @FinLit650, @AllenMoore, thank you both for your thoughtful comments
    The intent of this article is to think of student loans strictly from a financial perspective. The last paragraph of the article should not be discounted. Emotions do play a vital role when determining whether to pay off debt – if someone is debt averse, they should pay off their debt as quickly as possible. While the total interest paid increases by lengthening the loan term, the economics remain sound. Individuals should analyze the use of all non-revolving debt like any other investment – does the expected rate of return exceed the cost. Most individuals obtain college degrees to earn a higher income. If I spend $200,000 on an investment in myself, will I recoup that investment through a higher income? If the answer is no, I should not make the investment, whether I pay all cash or borrow at zero interest rate. But if the answer is yes, and I can borrow the money at a very low long-term fixed interest rate that exceeds my growth in income, I would make that investment every time. @FinLit650, you bring up an excellent point; Asset/Liability matching is also important. One should not fund a car loan over 30 years even if the interest rate is zero because a car is a depreciating asset and its useful life is far less than 30 years; however, since education debt is an investment in yourself, the individual is both (hopefully) an appreciating asset and has a useful life greater than the loan term.

    @FitLit650, I also completely agree with you that some students take on education loans for programs that don’t lead to gainful employment or they do not finish the program they start. Unless the person is seeking the degree for personal achievement, this would be a bad investment, regardless of whether the person borrowed the money or paid for school themselves.

    @AllenMoore, the majority of the student loans we see today for our clients are below 5 percent, not 6.9 percent.

    We should not underestimate the impact of inflation. Inflation is low now given the recent recession, but if history is any guide, inflation will pick up again. As stated in the article, if you are a fixed rate borrower, inflation is your friend. Lastly, if the economics stop making sense at any time, a borrower can always simply pay down their student loan debt.

  7. I disagree with this advice. The premise that if you pay off your student loan debt you are forgoing the purchase of a house is simply wrong. First of all, for many borrowers with 100k plus debt the debt to income ratio precludes the purchase of a house. Second, if a borrower chooses not to spend the money paying back the loans in advance, where is it ACTUALLY going to go? If it goes towards rent in a nicer building, a new car, or other expenses, the financially prudent move is to pay off your loans as soon as possible.

    People have an aversion to debt for good reason. Paying off your loans as soon as possible avoids the risk associated with a large amount of debt should you lose your job or income source.

    Waiting to pay off this debt only makes sense if you are working towards student loan forgiveness: http://studentloansherpa.com/repayment/student-loan-forgiveness/

  8. @The Student Loan Sherpa, thank you for your comment. My article does not state that if you pay off your student loans you are forgoing the purchase of a house; I simply use historical mortgage rates to support my point that interest rates are at historical lows and that there was a time when rates were in the double digits. While the debt/income ratio is important for obtaining a mortgage, there are many lenders that offer home loans to certain professions (medical, accounting, and legal) without including (or discounting) student loan obligations in their loan approval process. The aforementioned professionals are also the most prone to accrue $100,000+ in student loans. Also, I would never advocate someone make only the minimum payment on their student loan and use the additional funds toward consumption spending. I am simply stating that if someone has a student loan with a very low fixed interest rate, it make more economic sense to make the minimum payment and invest (not consume) the difference in a higher real (inflation adjusted) earning asset. To reiterate an earlier point, inflation is very important and should not be discounted. Inflation is very low right now; the government just reported that Personal Consumption Expenditures (an index used by the Fed to measure inflation) declined to 1 percent. If inflation picks up, it will erode the value of each fixed student loan payment over time.

    Respectfully,
    Ara Oghoorian

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  10. As a new attorney attempting to pay back approximately $120,000 in student loan debt, I have to say that I think this is horrific advice. Based off of my own life experience and everything I’ve read, Alan Moore is right. Repaying student loans now–aggressively–provides a guaranteed return equal to your loan’s interest rate. It feels like money down the drain but actually your increasing your net worth at a rate that’s better than most stocks and all bonds.

    Also, I find it shocking that this article failed to mention that the current rate of inflation is around 2% whereas Stafford loans range from 3.4% to 6.8%. (Private loans have interest rates that are considerably higher). These figures undermine this article’s basic premise that doing nothing puts you ahead. Under current conditions, the opposite is true.

  11. Dear Chris,
    Thank you for your comment. You are correct that paying off debt gives you a guaranteed rate of return; however, recent history supports my theses that you would have been better off making only the minimum payments versus making extra payments. Stocks have actually done quite well over the past couple of years so your net worth would have been higher had you made only the minimum payments on your student loan and invested the difference. Any extra payments you made toward your student loans simply earned the fixed rate of return whereas if you had invested in an S&P 500 index fund, you would have earned 13.41 percent in 2012 and 12 percent as of April 30, 2013.

    I want to reiterate that debt aversion is very important – if you are debt averse, then I encourage you to pay off your student loans as quickly as possible. Lastly, please refer to my earlier post on April 12, 2013 as it answers many of your concerns.

    Respectfully,
    Ara Oghoorian

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  13. Thanks for the reply, Ara. But, again I have to disagree with your conclusion. While it’s true that the SP500′s annualized return for 2012 was approximately 13.41%, in recent history that’s a total fluke. The average rate of return on the SP500 from 2000-2013 is dramatically lower. And–importantly–no one knows whether we’ll see continued growth through the rest of 2013 and into 2014 or if the market will revert.

    But, I take issue with other aspects of your article. First, your inflation argument is only valid if your clients’ student loans are incredibly low. Most people don’t have those loans; and with the rate of Stafford loans set to double, no one will ever have those loans. Second, you failed to offer any specifics in your article. Clients should be advised that everything depends on specifics: (a) private loans or public loans; (b) interest rates, (c) the outstanding balance, and (d) life goals. Third, your advice ignores the inherent risk involved in investing in the stock market which contrasts starkly with the fact that student loans are nondischargable at bankruptcy. Advising clients to transfer their investments from student loans–(which they are bound to and offer a guaranteed rate of return)–to the stock market based off of two years of good returns strikes me as risky business for young people who are saving for future children and houses.

    My apologies for my strong remarks. However, recent graduates are searching for excuses to not repay their debt because they are paralyzed with fear by the size of their obligations. I am surrounded by peers and co-workers who are doing nothing because they are scared, in denial, or simply don’t understand how their loans work vis-a-vis the economy as a whole. And, they are paying dearly for it.

    In my opinion, your article risks offering these people false hope by giving blanket advice that appears to apply to anyone with student loans. In reality, however, your advise only applies to a very, very small subsection of people who (1) have loans with very, very low rates and (2) happen to have invested in the right stocks at the right time.

    Warm regards.

  14. Jason,
    Thank you for your response. I would happy to continue this interesting dialogue with you. Please email me at aoghoorian@acapam.com.
    Regards.
    Ara Oghoorian

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