Student loan payments and opportunity costs

I’m about to graduate college and enter a very well-paid job in an inexpensive area. I am confident that I could repay my student loans much sooner than ten years, but I am wondering whether this is the right approach because there are a number of opportunity costs.

To take one example, the interest rate on even my most expensive student loan, the Parent PLUS loan, is 6.4%. Historically, the long-term return on the stock market is about 7%, and funds with low expense ratios can realize virtually all of that increase. I could do a half a percent better (on average), than paying early on even my worst loan, if I invested in the stock market instead of in early repayment. That’s a 13% additional return over 25 years. Buying a house may well be even better. I plan to invest for the long term and build my emergency fund with my interest payments in mind, so the added risk seems acceptable to me.

Is there any reason I shouldn’t opt for the longest, most graduated payment plan I am offered?

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10 Responses to “Student loan payments and opportunity costs”

  1. Already a lot of great answers, but since I ask myself this same question I thought I’d share my 2 cents.

    As @user541852587 pointed out, behavior is of the essence here. If you’re like most recent grads, this is probably the first time in your life you are getting serious about building wealth. Can you pay your loans down quickly and then have the discipline to invest just as much — if not more — than you were putting towards your loans? Most people are good at paying bills in full and on time, yet many struggle to “pay themselves” in full and on time.

    As @Brandon pointed out, you can do both. I find this makes a great deal of practical sense. It helps form good behaviors, boosts confidence, and “diversifies” those dollars. I have been paying double payments on my student loans while at the same time maxing out my IRA, HSA, & 401k. I also have a rental property (but that’s another can of worms). I’m getting on top and feeling confident in my finances, habits, etc. and my loans are going down. With each increase in pay, I intend to pay the loans down faster than I invest until they’re paid off.

    Again — I like the idea of doing both.

  2. The only real consideration I would give to paying off the debt as slowly as possible is if inflation were much higher than it is now. If you had a nice medium to low interest (fixed rate) loan, like yours, and then inflation spiked to 7-8%, for example, then you’re better off not paying it now because it’s effectively making you money (and then when inflation calms back down, you pay it off with your gains).

    However, with a fairly successful and active Federal Reserve being careful to avoid inflation spikes, it seems unlikely that will occur during your time owing this debt – and certainly isn’t anywhere near that point now. Make sure you’re saving some money not for the return but for the safety net (put it in something very safe), and otherwise pay off your debt.

  3. If I understand correctly, your question boils down to this:

    “I have $X to invest over 25 years, are guaranteed returns at a 0.6% lower rate better than what I expect to get from the stock market over the same period?”

    Well, I believe the standard advice would go something like:

    Rational investors pay a premium to reduce risk/volatility. Or, put another way, guaranteed returns are more valuable than risky returns, all things equal.

    I don’t know enough about student loans in America (I’m Australian). Here a student loan is very low interest and the minimum repayments scale with what you earn not what you owe, starting at $0 for a totally liveable wage – Here I’d say there’s a case to just pay the minimum and invest extra money elsewhere. If yours is a private loan though, following the same rules as other loans, remember the organisation extending your loan has access to the stock market too! why would they extend a loan to you on worse terms than they would get by simply dumping money into an index fund? Is the organisation that extends student loans a charity or subsidised in some way? If not, someone has already built a business on the the analysis that returns at 6.4% (including defaults) beats the stock market at 7% in some way.

    What I would put back to you though, is that your question oversimplifies what is likely your more complex reality, and so answering your question directly doesn’t help that much to make a persuasive case – It’s too mathematical and sterile. Here are some things off the top of my head that your real personal circumstances might convince you to pay off your loan first, hit up Wall Street second:

    • Is this “investment money” disposable? If the stock market were to take a bad turn between now and 25 years from now, would this put your loan at risk? if so, 25 years is an imaginary figure that you cannot achieve as you’ll be forced to exit the market at some point before then. The chance of there being no large recession events over the next 25 years that threaten your investment in the short-medium term are vanishingly slim.
    • If you die during a market downturn, will your loved ones be expected to foot the bill of the loan that you could have paid off but decided to visit Wall Street instead, and your relatives are now stuck “holding” all your shares until the market recovers or selling at a loss to partially cover the debt you left behind? Is this a concern for you?
    • While the market is often quoted as 7% long term historically, it’s not exactly 7% and when you say “historically”, do you mean since the beginning of time? over the last 25 years? between 9.8 and 32.774 years ago? the last 5 years? do you even know what “historically” means for future markets with enough accuracy to pinpoint growth rates of the whole market to 0.4% accuracy? (If you can do this, please just call Wall Street, they have a very, very well paid job for you that makes this discussion irrelevant)
    • Have you considered broker fees you will be paying in your equation of “7%”? You do not have all the money you want to invest up front, so you will need to pay many fees over time as you buy more shares gradually and every time you sell if you find yourself needing to. There are no fees to make a loan repayment.
    • How do you value your personal time spent researching individual shares and placing orders? You will need to spend many hours over 25 years carefully maintaining this, is your time free? I hope not. How much money could you earn freelancing/building a business for all those hours, how much value would you put on spending time with your family/friends all those hours? The alternative is to invest in a fund, how will you pick a “good” fund? How will you factor the fund fees (which are more than 0.6%) into your plans and still beat the 6.4% “guaranteed returns” of the loan?
    • Past performance does not indicate future returns. No, really, it doesn’t. If you think it does, you’re not ready for the stock market just yet, opportunity cost or not, please do some reading/experimenting and think over this proposition once more.
    • Is this investment exactly 25 years? what if a recession hits exactly 25 years from now? If we’re allowed to tweak your timeframes, what happens in the alternate scenario? If it’s 26 years and the 26th year is good enough to recover from a recession, can we consider a scenario where you pay your debt and add 1 good year on the stock market with what you’ve earned in the bad year?
    • What happens if you are hospitalised and expected to continue servicing your debt? Will this force you to withdraw money from the share market? Are you aware that the vast majority of stock market gains happen on only 1% of total trading days (it’s not a steady incline) and if you miss those days you completely miss out on the expected long term returns.
    • How does having an outstanding student loan impact your ability to take out other loans over the next 25 years? What is the opportunity cost of potentially finding it harder to take out loans at a more desirable rate when you really need to at some point? Will it be harder to secure a mortgage when the time comes (maybe it doesn’t, I don’t know American loans)?
    • As you do not have all the money up-front, it is incorrect to claim the 13% over 25 years on the full $X balance. You can claim 13% on the first investment you make, but a discounted % for subsequent payments. Your calculation also doesn’t take into consideration the effect of compounding interest on the loan or dividends paid (or not paid) by shares.
    • What kind of shares are you planning to buy? Individual companies perform very differently to the market average and many companies often go straight to $0. If you’re not risk adjusting your investment decisions, the type of portfolio you are likely to consider is likely to not line up with that 7% figure you quoted.
    • The difference in how much money you keep after tax between “not having to pay something” and “earning more money” is a big deal. Say you’re taxed 10% on all your income, you earn $100 each year from working and have to pay $10 each year to service a 10% loan you have for $100. If you invest the $100 this year to get 10% next year, you earn $110 next year, get taxed $11 (10%) and have to pay $10 to your loan, you’re left with $110 – $11 – $10 = $89. Say you pay off the loan this year instead, next year you earn $100 and are taxed $10, you’re left with $90. Even though the interest rate on your loan and your investment are identical, you have more money after tax by eliminating the loan rather than seeking investment return! The difference becomes more dramatic as your tax % increases.
  4. I agree with the advice given, but I’ll add another angle from which to look at it.

    It sounds like you are already viewing the money used to either pay off the loan early or invest in the market as an investment, which is great.

    You are wise to think about opportunity cost, but like others pointed out, you are overlooking the risk factor.

    The way I would look at this is: I could take a guaranteed 6.4% return by paying off the loan or a possible 7% return by investing the money. If the risk pays off modestly, all you’ve done is earned 0.6%, with a huge debt still hanging over you.

    Personally, I would take the guaranteed 6.4% return by paying off the debt, then invest in the stock market.

    Now this is looking at the investment as a single, atomic pool of money. But you can split it up a bit. Let’s say the amount of extra disposable income you want to invest with is $1,000/mo. Then you could pay an extra $500/mo to your student loan and invest the other $500 in the stock market, or do a 400/600 split, or whatever suits your risk tolerance.

    You mentioned multiple loans and 6.4% is the highest loan. What I would do, based on what I value personally, is put every extra penny into paying off the 6.4% loan because that is high. Once that is done, if the next loan is 4% of less, then split my income between paying extra to it and investing in the market.

    Remember, with each loan you pay off, the monthly income that previously went to it is now available, and can be used for the next loan or the other goals.

  5. I bought a house when I was 22, I also had $10k in student load debt. After the down payment, I had $1,500 to my name and $82k worth of debt. All the advice pointed to “pay the minimum payment and invest the rest.”

    I discarded the advice and scrimped and put everything extra to those bills.

    I paid it all off by the time I was 31, and now at 34 I’m self employed, have about $110,000 saved up, a house worth $105,000, 2 cars worth a total of $8,000 and no debt.

    Keep in mind most of those years I was making $24-$30k a year

    I might have lost out on a couple years of investments, but right now there are no money worries… wouldn’t you rather be like that instead of worrying if you might lose your job?

  6. As Mr. Money Money Mustache once said:

    IF YOU HAVE CREDIT CARD DEBT, YOU SHOULD FEEL LIKE YOUR HAIR IS ON
    FIRE

    Student loan debt is different than credit card debt. Rather than having spent the money on just about anything, it was invested in improving yourself and probably your financial future. This was probably a good decision.

    However, unlike most credit card debt, if you ever have to file for bankruptcy, your student loans will not be erased. They will follow you forever.

    Pay your debts off as quickly as you can. While it may be true that “long-term return on the stock market is about 7%”, you cannot assume that this will always be the case, especially in the short term. What if you had made this assumption in 2007?

    To assume that your stocks will beat a 6.4% guaranteed return over the next few years is not really investing. It’s gambling.

  7. Ponder this. Suppose that a reputable company or government were to come out and say hey, we are going to issue some 10 year bonds at 6.4%. Anyone interested in buying some? Assume that the company or government is financially solid and there is zero chance that they will go bankrupt. Think those bonds would sell? Would you be interested in buying such a bond?

    Well, I would wager that these bonds would sell like hotcakes, despite the fact that the long term stock market return beats it by a half percent. Heck, vanguard’s junk bond fund is hot right now. It only yields 4.9% and those are junk bonds, not rock solid companies (see vanguard high yield corporate bond fund)

    Every time you make an extra principal payment on your student loan, you are effectively purchasing a investment with a rock solid, guaranteed 6.4% return for 10 years (or whatever time you have left on the loan if make no extra payments).

    On top of that, paying off a loan early builds your credit reputation, improves your monthly cash flow once the loan is paid, may increase your purchasing power for a house or car, and if nothing else, it frees you from being a slave to that debt payment every month.

    Edit Improved wording based on Ross’s comment

  8. Staying with your numbers – a 7% long term return will have a tax of 15% (today’s long term cap gain tax) resulting in a post tax of 5.95%. On the other hand, even if the student loan interest remains deductible, it’s subject to phaseout and a really successful grad will quickly lose the deduction.

    There’s a similar debate regarding mortgage debt. When I’ve commented on my 3.5% mortgage costing 2.5% post tax, there’s no consensus agreeing that this loan should remain as long as possible in favor of investing in the market for its long term growth. And in this case the advantage is a full 3.45%/yr. While I’ve made my decision, Ben’s points remain, the market return isn’t guaranteed, while that monthly loan payment is fixed and due each month.

    In the big picture, I’d prioritize to make deposits to the 401(k) up to the match, if offered, pay down any higher interest debt such as credit cards, build an emergency account, and then make extra payments to the student loan.

    Keep in mind, also – if buying a house is an important goal, the savings toward the downpayment might take priority. Student Loans and Your First Mortgage is an article I wrote which describes the interaction between that loan debt and your mortgage borrowing ability. It’s worth understanding the process as paying off the S/L too soon can impact that home purchase.

  9. I’ll use similar logic to Dave Ramsey to answer this question because this is a popular question when we’re talking about paying off any debt early. Also, consider this tweet and what it means for student loans – to you, they’re debt, to the government, they’re assets.

    If you had no debt at all and enough financial assets to cover the cost, would you borrow money at [interest rate] to obtain a degree? Put it in the housing way, if you paid off your home, would you pull out an equity loan/line for a purchase when you have enough money in savings? I can’t answer the question for you or anyone else, as you can probably find many people who will see benefits to either.

    I can tell you two observations I’ve made about this question (it comes a lot with housing) over time. First, it tends to come up a lot when stocks are in a bubble to the point where people begin to consider borrowing from 0% interest rate credit cards to buy stocks (or float bills for a while). How quickly people forget what it feels (and looks like) when you see your financial assets drop 50-60%! It’s not Wall Street that’s greedy, it’s most average investors. Second, people asking this question generally overlook the behavior behind the action; as Carnegie said, “Concentration is the key to wealth” and concentrating your financial energy on something, instead of throwing it all over the place, can simplify your life. This is one reason why lottery winners don’t keep their winnings: their financial behavior was rotten before winning, and simply getting a lot of money seldom changes behavior. Even if you get paid a lot or little, that’s irrelevant to success because success requires behavior and when you master the behavior everything else (like money, happiness, peace of mind, etc) follows.

  10. My recommendation would be to pay off your student loan debt as soon as possible.

    You mention that the difference between your student loan and the historical, long-term return on the stock market is one-half percent. The problem is, the 7% return that you are counting on from the stock market is not guaranteed. You might get 7% over the next few years, but you also might do much worse. The 6.4% interest that you will save by aggressively paying off your debt is guaranteed.

    You are concerned about the opportunity cost of paying your debt early. However, this cost is only temporary. By drawing out your debt payments, you have a long-term opportunity cost. By this, I mean that 4 years from now, you could still have 6 years of debt payments hanging over your head, or you could be debt free with all of your income available to save, spend, or invest as you see fit.

    In my opinion, prolonging debt just to try to come out 0.5% ahead is not worth the hassle or risk.