Student loan payments and opportunity costs
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 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. 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. "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." "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." "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?" 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. "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:" 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. "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."
I agree that college doesn't or shouldn't have to be all about job prep.   However, the caveat I will add is that if you go into DEBT for your education, you should certainly be thinking about the economic value your education can provide you.   The last point about subsidized college being cheaper than the current system.. I don't know.. I'd have to see these reports you speak of, and who made them, and for what incentive.  At the end of the day though, these findings are all moot unless we can have a conversation about the hyperinflation in college costs directly related to 'free' aka subsidized education. Excellent question and it is a debate that is often raised.  Mathematically you are probably best off using option #1.  Any money that is above and beyond minimum payments earns a pretty high interest rate, about 6.82% in the form of saved interest payments. The problem is you are likely to get discouraged.  Personal finance is a lot about behavior, and after working at this for a year, and still having 5 loans, albeit a lower balance, might take a bit of fight out of you. Paying off such a large balance, in a reasonable time, will take a lot of fight. With the debt snowball, you pay the minimum to the student loan, save in an outside account, and when it is large enough, you execute option #2.  So a year from now you might only have three loans instead of five.  If you behaved exactly the same your balance would be higher after that year then using the previous method. However often one does not behave the same.  Because the goals are shorter and more attainable it is easier to delay some gratification.  The 8 dollars you are saving in your weekly gas budget, because of low prices, is meaningful when saving for a 4K goal, where it is meaningless when looking at it as a 74K goal.  With the 4K goal you are more apt to put that money in your savings, where the 74K goal you might spend it on a latte. For me, the debt snowball worked really well. With either option make sure that excess payments actually go to a reduction in principle not a prepayment of interest.  Given this you may be left with no option.  For example if method #1 you only prepay interest, you are forced to use option #2. Actually, a few lenders now will offer a consolidation loan that will consolidate both Federal and private student loans. One example is Cedar Ed, http://cedaredlending.com/PrivateConsolidationLoan.htm Hi guys, have a question from my uni finance course but I’m unsure how to treat the initial loan (as a bond, or a bill or other, and what the face value of the loan is).  I’ll post the question below, any help is appreciated.  “Hi guys, I have a difficult university finance question that’s really been stressing me out....  “The amount borrowed is $300 million and the term of the debt credit facility is six years from today  The facility requires minimum loan repayments of $9 million in each financial year except for the first year.  The nominal rate for this form of debt is 5%. This intestest rate is compounded monthly and is fixed from the date the facility was initiated.  Assume that a debt repayment of $10 million is payed on 31 August 2018 and $9million on April 30 2019. Following on monthly repayments of $9 million at the end of each month from May 31 2019 to June 30 2021.  Given this information determine the outstanding value of the debt credit facility on the maturity date.”  Can anyone help me out with the answer? I’ve been wracking my brain trying to decide if I treat it as a bond or a bill.”  Thanks in advance, I wasn't 100% on which columns of the scale you were referring to, but think I captured the correct ones in this comparison, using the scale for BA and MA (MA scale starting 2 years later, with decreased income reflected for first two years), applying a 1% cost of living increase each year to the scale or to prior year after the scale maxes out and assuming you borrow 40k and repay years 3-10, then the difference and cumulative difference between each scenario:  So it would be about 16 years to start coming out ahead, but this doesn't account for the tax deduction of student loan interest. Some things in favor of borrowing for a MA, there are loan forgiveness programs for teachers, you might only make 5-years of minimum payments before having the remainder forgiven if you qualify for one of those programs. Not sure how retirement works for teachers in WA, but in some states you can get close to your maximum salary each year in retirement. Additionally, you can deduct student loan interest without itemizing your tax return, so that helps with the cost of the debt. Edit: I used a simple student loan calculator, if you financed the full 40k at 6% you'd be looking at $444 monthly payments for 10 years, or $5,328/year (not calculating the tax deduction for loan interest). Is there anything here I should be deathly concerned about? A concern I see is the variable rate loans. Do you understand the maximum rate they can get to? At this time those rates are low, but if you are going to put funds against the highest rate loan, make sure the order doesn't change without you noticing it. What is a good mode of attack here?  The best mode of attack is to pay off the one with the highest rate first by paying more than the minimum. When that is done roll over the money you were paying for that loan to the next highest. Note if a loan balance get to be very low, you can put extra funds against this low balance loan to be done with it. Investigate loan forgiveness programs. The federal government has loan forgiveness programs for certain job positions, if you work for them for a number of years. Some employers also have these programs.  What are the payoff dates for the other loans? My inexact calculations put a bunch in about 2020 but some as late as 2030. You may need to talk to your lender. They might have a calculator on their website.  Why do my Citi loans have a higher balance than the original payoff amounts? Some loans are subsidized by the federal government. This covers the interest while the student is still in school. Non-subsidized federal loans and private loans don't have this feature, so their balance can grow while the student is in school. There are many ways to temper the dollar burden of an education.  Your question has very little information, so I am going to assume the following:  You are attending a University in the United States, you are paying for school with a combination of loans, scholarships, gifts, and your own income, and that you are a typical (socially) 18-22 year old male/female. Tuition Food Alcohol and Social Activities Books Room/Board/Transportation Income  (I don't have as much advice here, someone else will need to chime in) Lets pretend that your parents were given the opportunity to pay X for a year of college tuition in the year that you were born. That would have been a significant portion of their yearly income.  But what if they were given the opportunity to pay for that year of college when you are 18, but at the price it was when you were born. That tuition bill would be much easier to pay. That would be a very small amount of their yearly income.  Why? the cost of tuition grew at a high inflation rate, but the second option allowed them to skip inflation on the bill side, but keep inflation regarding wages. You asked about paying for stuff you want today with future money; where my example was to pay new money for old expenses.  If you believe that inflation will be high,and your income will keep up with it; it is advantageous to pay with future $'s You might try to refinance some of those loans. It sounds like you are serious about minimizing interest expense, if you think you will be able to pay those loans in full within  five years you might also try a loan that is fixed for five years before becoming variable.  If you do not think you can repay the loans in full before that time, you should probably stick with the fixed rates that you have. It may even be profitable to refinance those loans through another lender at the exact same fixed rate because it gets around their repayment tricks that effectively increase your interest on those two smaller loans. "It appears you can elect to classify some or all of your scholarship money as taxable.  If you do this, you would be deemed to have used the scholarship funds for non-deductible purposes (e.g., room and board), and you could be eligible to claim the American opportunity credit based on the money you used to pay for the tuition out of your own pocket. I found this option in the section of Publication 970 about ""Coordination with Pell grants and other scholarships"", specifically example 3: The facts are the same as in Example 2—Scholarship excluded from income [i.e., Bill receives a $5600 scholarship and paid $5600 for tuition]. If, unlike Example 2, Bill includes $4,000 of the scholarship in income, he will be deemed to have used that amount to pay for room and board. The remaining $1,600 of the $5,600 scholarship will reduce his qualified education expenses and his adjusted qualified education expenses will be $4,000. Bill's AGI will increase to $34,000, his taxable income will increase to $24,250, and his tax before credits will increase to $3,199. Based on his adjusted qualified education expenses of $4,000, Bill would be able to claim an American opportunity tax credit of $2,500 and his tax after credits would be $699. You can only reclassify income in this way to the extent that your scholarship allows you to use that money for nonqualified expenses (such as room and board).  You should carefully check the terms of the scholarship to determine whether it allows this.  The brief paragraph you cite from the Palmetto fellowship document is not totally clear on this point (at least to my eye).  You might want to ask the fellowship administrators if there are restrictions on how they money may be used. In addition, I would be cautious about attempting to do this unless you actually did pay for the nonqualified expenses yourself, so you can treat the money as fungible.  If, for instance, your parents paid for your room and board, it's not clear whether you could legitimately claim that you used the scholarship money to pay for that, since you didn't pay for it at all (although in this case your parents could possibly be able to claim the AOC themselves).  I mention this because you say in your question that you ""only used the scholarship for tuition and fees"".  I'm not sure how exactly you meant that, but it seems from the example cited above that, in order to claim the scholarship as taxable income, you have to actually have nonqualified expenses which you can say you paid for with the scholarship.  (Also, of course, you had to actually receive the money yourself.  If the scholarship money was given directly to your school as payment of tuition, then you never had any ability to use it for anything else.)" Depending on the student loan, this may be improper usage of the funds.  I know the federal loans I received years ago were to be used for education related expenses only.  I would imagine most, if not all, student loans would have the same restrictions. Bonus Answer: You must have earned income to contribute to an IRA (e.g. money received from working (see IRS Publication 590 for details)).  So, if your earmarked money is coming from savings only, then you would not be eligible to contribute.  As far as whether you can designate student loans for the educational expenses and then used earned income for an IRA I would imagine that is fine.  However, I have not found any documentation to support my assumption. The short answer is that you can use student loans for living expenses.  Joe provides a nice taxonomy of loans.  I would just add that some loans are not only guaranteed, but also subsidized.  Essentially the Government buys down the rate of the loan. The mechanics are that a financial aid package might consist of grants, work study (job), subsidized, and guaranteed loans.  One can turn down one or more of the elements of the package.  All will be limited in some form. The work study will have a maximum number of hours and generally has low pay.  Many find better deals working in the businesses surrounding the college or starting their own services type business.  The grants rarely cover the full cost of tuition and books.  The loans will both be limited in amount.  It mainly depends on what you qualify for, and generally speaking the lower the income the more aid one qualifies for. Now some students use all their grant, all their loan money and buy things that are not necessary.  For example are you going to live in the $450/month dorm, or the new fancy apartments that are running $800/month?  Are you going to use the student loan money to buy a car?  Will it be a new BMW or a 8 year old Camary? I see this first hand as I live near a large university.  The pubs are filled with college students, not working, but drinking and eating every night.  Many of them drive very fancy cars. The most onerous example of this is students at the military academies.  Attendees have their books and tuition completely paid for.  They also receive a stipend, and more money can be earned over the summer.  They also all qualify for a 35K student loan in their junior year.  Just about every kid, takes this loan.  Most of those use the money to buy a car.  I know a young lady who did exactly that, and so did many of her friends. So kids with a starting pay of 45K also start life with a 35K.  Buying a nice car in the military is especially silly as they cannot drive it while deployed and they are very likely to be deployed.  At least, however, they are guaranteed a starting job with a nice starting pay, and upward potential. College kids who behave similarly might not have it as good.  Will they even find work?  Will the job have the ability to move up?  How much security is in the job?  One might say that this does not apply to engineers and such, but I am working with a fellow with a computer science degree who cannot find a job and has not worked in the past 6 months.  This even though the market is super hot right now for computer engineers. So, in a word, be very careful what you borrow. Considering I'm in a nearly identical situation, I'll speak to my personal strategy and maybe there's some value for you as well.   You have ~$22k in loans, which you say you could pay off today.  So, what I read is that you're sitting there with a $22k investment and want to know which investment to make: pay down debt, invest in yourself/start up, or some variation between those options.  Any investor worth his salt will ask a couple of questions: what is my risk, and what is my gain? Paying off your student loans offers no financial risk at the cost of opportunity risk, and gains you returns of 3.4%, 6.8%, 3.4%, 4.5%, and 6.8%.  Those percentage gains are guaranteed and the opportunity risk is unknown. Investing in a startup is inherently risky, with the potential for big payoffs. But with this investment, you are accepting a lot of risk for potentially some gain (it could be the next Apple, it could also fail).  So, with your situation (like mine), I'd say it's best to accept the easy investment for now and fully vet out your tech start up idea in the meantime. "Assuming the numbers in your comments are accurate, you have $2400/month ""extra"" after paying your expenses.  I assume this includes loan payments. You said you have $3k in savings and a $2900 ""monthly nut"", so only one month of living expenses in savings. In my opinion, your first goal should be to put 100% of your extra money towards savings each month, until you have six months of living expenses saved.  That's $2,900 * 6 or $17,400.  Since you have $3K already that means you need $14,400 more, which is exactly six months @ $2,400/month. Next I would pay off your $4K for the bedroom furniture.  I don't know the terms you got, but usually if you are not completely paid off when it comes time to pay interest, the rate is very high and you have to pay interest not just going forward, but from the inception of the loan (YMMV--check your loan terms). You may want to look into consolidating your high interest loans into a single loan at a lower rate.  Barring that, I would put 100% of my extra monthly income toward your 10% loan until its paid off, and then your 9.25% loan until that's paid off.  I would not consider investing in any non-tax-advantaged vehicle until those two loans (at minimum) were paid off.  9.25% is a very good guaranteed return on your money. After that I would continue the strategy of aggressively paying the maximum per month toward your highest interest loans until they are all paid off (with the possible exception of the very low rate Sallie Mae loans).  However, I'm probably more conservative than your average investor, and I have a major aversion to paying interest.  :)" Thanks for explaining added value - I do not think professors are much, if any part of the problem, it really does come down to cost in my eyes. Year over year costs go up. As a country we are pricing ourselves out of education. It will continue to create disparity and eventually you will have a large segment of the population saying no way on college (I can get a lot of free courseware on edx.org and other sites).   As numbers drop colleges are going to be hard pressed to really make money.  I often ponder what that money is spent for. I know a chunk goes to sports and other not necessarily academic activities.  I have advocated for years to people who cannot afford to go to a 4yr college to attend community college, get an Associates and make their decision from there.   With exception of the Ivy league schools I do not think there is enough value in 4 yr degree's in the job market. I am in IT and the number of people I have worked with who have had degrees since the early days of my career has dropped greatly. Many of them had non-computer degrees and jumped job fields to fill gaps early on.  Just my two cents. I really believe that most professors are not the problem (unless they are paid huge sums and even that's dependent on a lot of things)