How to Invest When You’ve Got Monster Student Debt
The following post from Travis from Student Loan Planner.
It might be an easy decision to side hustle your way out of your $20,000 of undergrad student debt. However, what happens when you owe a multiple of your income? This kind of monster debt is very common after grad school, and it can leave you paralyzed financially.
Why invest when you are staring back at a statement from a student loan servicer with an amount that’s more than most people owe on their mortgage? You want to figure out if you should go for forgiveness or not, max your retirement accounts, and make sure your net worth grows faster than your debt accumulates.
Deciding What Path to Take with Your Huge Student Debt
Pretend for a moment you went to law school and left with $200,000. You earn about $80,000. While you could cut your interest and try to swing payments of more than $2,000 a month, you are worried you won’t have much to show for it at the end of 10 years when you’re debt free.
Generally, I suggest paying back your student debt if you owe less than 1.5 times your income. If you owe two times your income or more, forgiveness is generally better. If you’re in between these ratios, you can make your own decision as to what makes you feel more comfortable.
If you do decide on forgiveness, you need to set up a tax bomb account. After all, the forgiven balance on an income-driven plan is taxable income after 20-25 years of payments. Luckily, you can save a few hundred dollars per month to cover this tax liability.
A side note: if you work in the public sector you might be able to get out of this tax bomb with the PSLF program. Even then, you should grow your assets by investing in the brokerage account as a “back-up plan” in case the government program unexpectedly takes a hit.
For what it’s worth, my company Student Loan Planner has found that a lot more people should be going for forgiveness.
Why Retirement Savings Take a Priority Over Student Debt
When you contribute to a 401k pre-tax, your student loan payment decreases. This is because the payment is based on your taxable income. That income goes lower the more you put into retirement. That means you’d want to contribute the maximum of $18,500 per year if you can afford to.
Also, big student debt grows at a rate of simple interest because of government subsidies. Retirement accounts grow at rates of compounding interest. You can’t go back in time and try to contribute more to retirement.
Since you reduce your student loan payment when you contribute to retirement and cut your taxes, the government really encourages folks with big student loans to contribute heavily to retirement accounts.
You will be in a way better position if you have significant retirement assets while still having student debt than having 0 debt but having nothing to show for it.
Focus on Increasing Your Assets If This Rule Holds True
Unless you can’t easily pay down your debt within five years with a private refinancing, you should focus on increasing your assets. What do I mean by this? For the most part, I like retirement accounts and non-retirement brokerage accounts, though many friends of mine also include rental real estate in the picture.
The math for forgiveness with PAYE or REPAYE is powerful if you owe more than two times your income. This is particularly true if you qualify for the 10-year version of forgiveness under the PSLF program if you work in the public sector.
That said, the math of “tax bomb” forgiveness works for anyone whose monster student debt will likely always be more than their income.
Here’s why you would invest even with the stock market at record highs while you’re dealing with 7% student debt. The interest on federal student loans accrues, it does not compound.
That means your 7% student debt actually grows at a linear rate instead of an exponential rate. As long as you don’t dump a bunch of money into cryptocurrency that has no predictable long-term return, you can gamble on the economy growing over time with a broadly diversified index fund.
A compound return beats a simple rate of return often even when it’s lower on a percentage basis. I would rather get a 5% compounded over a 7% linear rate of growth.
To see this, know that it takes $1,000 14 years to double at 5%. However, it takes slightly longer than that for 7% simple interest to accumulate a $1,000 charge.
Get to Positive Net Worth and You Can’t Go Wrong
It’s hard to know who you can trust in this world where student debt has quintupled over a very short time frame. One thing I know for sure is that you won’t be upset if you have a positive net worth that continues to grow over time. That means getting your student loans managed to stop the bleeding, maxing your retirement accounts, and putting at least something in a non-retirement brokerage account along the way.
Thank you, Travis for sharing your insight in managing student loans.