Last week’s Astute Angle post explained some fallacies related to mortgage borrowing and how the free pass treatment of home mortgages as “good debt” leads to poor financial decision-making. In response to that post, I received a few questions related to the “good debt” label of student loans that prompted another debt-centric post. Three of those questions are addressed below.
Is it fair to consider student loans used to finance the cost of college or graduate school as good debt?
Unfortunately, this pervasive tendency to blindly label post-secondary education loans as “good debt” is terribly flawed. Borrowing money to finance a bad investment just turns a bad investment into a really bad investment. Which is to say that just because lenders might provide a 6-figure loan to fund four years of drinking, partying, and a fine arts degree does not somehow magically make this “good debt.”
If evaluating things from an economic perspective, the important questions are not “How much student debt can I afford?” or “Can I cover the required payments on this debt after graduation?” Instead, the economic question that needs to be addressed is whether the expected lifetime value of the education, in light of the full costs of college (ignoring any borrowing), provides a good return on investment.
Spending $60,000 per year for 4 years of private college to get a theater degree and earn an additional $15,000 per year (inflation adjusted) for 35 years beyond what could have been earned without a college degree results in a negative return on investment regardless of whether it is financed or paid in cash.[i]
The key point is this: determining whether to assume student loans depends entirely on the value of the education relative to the cost of the education, independent of the financing. Only if this math comes out positive can any student debt, regardless of the amount, be appropriately regarded as “good debt.”
If I determine, based on specific circumstances, that my borrowing for education qualifies as good debt, what is the maximum amount that I should consider borrowing?
A good and simple rule to follow on student loans is that total borrowing should never exceed expected first-year post-graduation salary. For example, someone studying to be an engineer where the average starting salary (depending on the specific field) tends to be in the $80,000 – $100,000 range would be wise to limit total college borrowing to $80,000 – $100,000. Someone studying to be a social worker, alternatively, should plan to borrow no more than about $35,000 in total loans. Note that this is not the suggested borrowing amount – it is the maximum amount that anyone should ideally borrow.
The economic rationale for this rule is based on the required monthly payments after graduation that come with the debt. The math depends on the interest rates and the loan terms but someone with $50,000 in student loans at an average rate of 6% and a 10-year term will face required monthly payments of $555. This monthly expense is likely to create a very tight, albeit manageable, budget for someone earning $50,000 – $60,000 per year. However, such a monthly expense is likely to be insurmountable for a recent graduate making $40,000 per year and will effectively force he/she to move in with mom and dad just to be able to afford the loan repayment.
Your post explained why for many people, their mortgage is effectively just a loan that allows them to invest more in stocks and bonds. I assume the same logic is true for old student loans. With that in mind, should I sell investments to pay off my student loans that carry an interest rate of 6.5%?
In fairness, there’s not one simple answer to this question. With student loans, a number of important factors have to be considered such as:
- Does selling investments to pay off the loan result in a large capital gain realization?
- Can the loans be refinanced to a lower rate?
- Do the loans qualify for any of the forgiveness programs such as PSLF or forgiveness at death that may be applicable?
- Is the loan interest fully deductible or does high income reduce or eliminate the deduction?
Now, if we assume that these factors do not apply to this situation, then paying down the student loans provides the equivalent of a guaranteed and risk-free 6.5% rate of return (pre-tax). While someone might expect a long-term return of 6.5% or higher from an investment portfolio, getting this type of return in today’s low rate environment requires assuming significant risk. There is clearly a huge difference between a risk-free 6.5% return (via debt prepayment) and a 6.5% return by investing in stocks or other high yield investments that stand to suffer sharp losses. In this sense alone, the 6.5% guaranteed return is advantageous if the alternative is a volatile investment portfolio that might make 6.5% over the next decade if things go well.
But it’s not this simple. Imagine you have $50,000 remaining on this 6.5% student debt and a required monthly payment of $675. Electing to take funds from your investment portfolio to pay off the debt means that you avoid the $675 monthly payment. But what often happens is that someone pays off the debt early and then fails to invest the $675 of saved expense each month. If you allow some or all of this $675 to get absorbed into spending or just fail to reinvest this amount each month, then the lifetime economics of the accelerated debt repayment strategy may actually be a negative rather than a positive.
So, if you’re employing this strategy, just be sure that you have the self-discipline to reinvest the savings each month or you may be better off with the “forced savings” plan of leaving things as they are and making the required debt payment each month.
Have additional questions or comments? Please share them in the comments section below.
[i] This is just a net present value calculation that assumes inflation of 2.5%, uses a discount rate of 6.5% (which can represent either the cost of financing or the opportunity cost of what the college costs might have earned if invested), and assumes that the lost income for the 4 years of college was $30,000/year (present dollars). The NPV here comes to a negative $99,708.