Should You Invest or Pay Off Student Loans?

Stick with me for a moment and humor me on my mental parallel for how I think about whether you should invest or pay off student loans.  You may find the analogy appropriate for your understanding of how to address this fundamental question. In middle school, my physical education class played dodgeball.  I was heavier back then and not known for my athletic abilities. I never got selected first when it came time to choose teams.  The first picks were inevitably the fastest, most athletic and aggressive kids.  When the starting whistle blew these kids ran to midcourt and immediately started pegging the other team with near reckless abandon. They really shined as they mowed their way through the weakest links on the opposing team.  However, because of their risky behavior, they often found themselves blind-sided by even the meekest opposing player. That left you with people like me.  I was always on the defensive and hid in the back.  Not necessarily because I had a fear of getting hit (well, maybe a little), but because I played a more conservative style. After the easy targets went down, that left me as the person responsible for catching the balls thrown my way.  I wasn’t fast, but I had coordination. I always found the best teams had a healthy balance of super aggressive kids hell bent on getting as many opposing members out as possible and the conservative players who could catch very well. This diversification is important for building a resilient team and increasing the probability for reaching the highest expected return.  In the case of dodgeball, wins. The lesson I learned from dodgeball also applies for deciding what to include in your investment portfolio.  You should look to maximize your expected return by buying attractive stocks and paying off costly student loans early. In the dodgeball analogy, your super aggressive kids and your conservative players work best on a team.  In allocating money, both stocks and paying off student loans can fit nicely into the optimal, diversified portfolio.

Invest or Pay Off Student Loans? Look at the Expected Return

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We all strive to build wealth and grow our net worth, which calculates simply as: Assets – Liabilities = Net Worth/Equity As you can see, to increase your net worth you must increase your assets, decrease your liabilities or some combination of both. When building your net worth, the surest path involves making regular, sizable contributions and maximizing your expected return on your investments. Following this logic, when deciding whether to invest or pay off student loans early, you should consider the after-tax expected return on the investment or after-tax interest rate on your student debt as a range of return possibilities.  This also applies to all types of debt. What do I mean by this?  Take the following example: you can either invest in a low-cost, passive index fund expected to return 10% or make extra payments toward your outstanding student loan balance carrying a 4.5% interest rate. Suppose you pay over $2,500 per year in interest (the maximum income tax deduction allowed on qualified student loans).  When calculating the effective interest rate, net of tax savings, you will have a lower expected return than the 4.5%. Likewise, with the passive index fund, you may have a price appreciation of 9% and a dividend of 1%. Both are taxable (dividend when received, stock when sold) and would reduce your expected return at your marginal tax rate or long-term capital gains rate. You should also consider the affects on inflation on this return.  With this background, which choice should you make? Speaking purely from an economic perspective of maximizing your expected return, 10% > 4.5% and therefore you should choose to invest in the index fund.  However, this decision might not be so straightforward.  Debt carries added risk and not all of it is created equal.

Factors Affecting Your Risk Tolerance

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Maximizing your contributions and expected return is the rationed, economic approach to investing your money.  But when you’ve got a heavy debt burden, thinking about it rationally can be a challenge as risk tolerance plays a part. Risk tolerance, which is the degree of variability in investment returns an individual is willing to withstand, depends on a number of factors.  Major ones include: 1. Age – Your age and stage of life can determine how much risk you can tolerate. If you’re young with less to lose, you can shoulder more risk with investing.  Similarly, if you’re older with more assets at-risk, you want to preserve your wealth.  In response, you could choose to hold more cash and fixed-income investments and not carry much debt. 2. Income – Closely related to age, your disposable income plays a role (income available after paying for living expenses). If you’re young and invincible and on a high deductible health plan, you likely don’t have many obligations outside of rent, food, entertainment, and repaying your student loans.  You might make less but still have more disposable income than someone a bit older who is married with kids.  With no dependents, you can have a higher risk tolerance and invest more aggressively instead of paying down student loans.  However, as an alternative to paying off student loans, you may also face the decision of whether you should pay off student loans or mortgage. 3. Time Horizon – The amount of time you have to invest or repay your loans affects your risk tolerance. When you’re young and can afford to hold riskier assets, you have a greater potential payoff through investing rather than reducing debt.  Also, federal student loans accrue interest, they don’t compound.  That gives an advantage to investing again.  There are also options other than repaying the entire balance.  For example, some student loans qualify for the Public Service Loan Forgiveness program (PSLF), discussed below.  You can also lower the cost burden by refinancing student loans. 4. Debt Amount – If the debt is very large relative to your income and feels cumbersome, you might prefer to pay off your debt sooner. In the case where PSLF or other loan forgiveness isn’t an option you should probably put more money toward repaying the loans to suit your risk tolerance. Now that you know about risk tolerance factors, let’s explore options for dealing with the debt. The first option you should consider is refinancing.  If you can lower the interest rate and bring down the total cost to be repaid, you should pursue this opportunity.

What are Student Loans?

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Many companies cater to the student loan market.  I suggest looking at Splash Financial’s site for refinancing options or contacting credit unions.  Because credit unions are not-for-profit they can offer very better rates than banks but Credible offers competitive rates as well. My wife and I used a service like Splash Financial to find a lender to refinance the first batch of her loans.  She began paying after she finished medical school and made a significant dent before we married.  We made repayment easier by refinancing and lowered her rate by 515 basis points (8.00% to 2.85%). For the loans we chose to refinance on a site like Splash Financial, despite receiving a generous student loans tax deduction for the interest paid, we still opted to pay off the loans. We felt it was more important to pay off student loans and maximize our savings in our 401k and IRAs. Those loans were manageable relative to our income. Later, after relocating to northern California, we chose to refinance more of her student loans with First Republic Bank, a bank offering highly competitive loan terms should you live in one of the regions where they serve customers. If you have a large student debt burden (2x or greater than your annual income), you might consider another option, the PSLF.  This program forgives your remaining loan balance after making 120 monthly payments (10 years). The IRS awards another benefit to the program by not having the forgiven loan balance count as income.  So when the remaining balance is forgiven, it does not qualify as a taxable event. To qualify for PSLF, you must:

• Have a non-defaulted loan received under the Direct Loan Program,
• Complete and submit the Employment Certification form,

Be employed full-time by a:

• government organization at any level (federal, state, local or tribal)
• not-for-profit organization that is tax-exempt under Section 501(c)(3) of the Internal Revenue Code, or
• Other type of not-for-profit that is not tax-exempt if their primary purpose is to provide types of qualifying public services
• Make 120-qualified monthly payments based on an income-driven repayment plan

What are Income-Driven Repayment Plans?

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The income-driven 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.  Income-driven repayment plans not under PSLF range from 20-25 years. The table below shows the available income-driven repayment plans.  To estimate your income-driven loan repayment amount, use the Federal Student Aid site’s repayment calculator.

Income-Driven Repayment Plan	Payment Amount
Revised Pay As You Earn Repayment (REPAYE) Plan	Generally, 10% of your discretionary income
Pay As You Earn (PAYE) Plan	Generally, 10% of your discretionary income, but never more than the 10-year Standard Repayment Plan amount
Income-Based Repayment Plan (IBR) Plan	Generally, 10% of your discretionary income if you’re a new borrower on or after 7/1/14*, but never more than the 10-year Standard Repayment Plan amount Generally, 15% of your discretionary income if you’re not a new borrower on or after 7/1/14, but never more than the 10-year Standard Repayment Plan amount
Income Contingent Repayment (ICR) Plan	The lesser of the following: • 20% of your discretionary income or • what you would pay on a repayment plan with a fixed payment over the course of 12 years, adjusted according to your income

Source: Federal Student Aid website

Why You Should Invest Under This Scenario

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As a useful tip for qualifying for Public Service Loan Forgiveness, you have an incentive to maximize any pre-tax contributions to your tax-advantaged investments.  This means knowing how to save money and maxing out your traditional 401(k), individual retirement account (IRA), and health savings account (HSA) contributions.  Doing so lowers your discretionary income and the amount you will have to repay over 10 years. You should not pay extra toward your debt under PSLF. Per the Federal Student Aid website:

“If you make a monthly payment for more than the amount you are required to pay, you…can receive credit for only one payment per month, no matter how much you pay…However, if you do want to pay more than your required monthly payment amount…you may end up being paid ahead, and you can’t receive credit for a qualifying PSLF payment during a month when no payment is due.”