The Student Loan Dilemma
A friend of mine the other day asked me whether they should devote some of their income to saving or pay it all to student loans. I figured other people might want to know the answer to that good question.
Many young professionals out there probably have some sort of debt, be it for a car loan or for the ever common student loans that got us through college. I’ve debated with other people who are wise about money over the merits of getting out of debt ASAP or saving a fair percentage. My thought is that after building up a healthy emergency fund, you should focus the bulk of your income into paying down the debt.
You’ve hopefully paid attention to your debt level and if you weren’t familiar before, are now well versed in the power of interest. Every month you seem to owe a bit more, despite making monthly payments. I’ll discuss student loans but the same principle holds for other types of debt. The typical student loan carries an interest level of 6 to 8%. This means that for every time frame of the loan, your unpaid, or ‘outstanding’ debt increases by 6 to 8%. The rather unfortunate thing is that if you owe $100, it’d be $108, then not $116, but $116.64, and so on. The one reason I hear that people save more instead of paying debt is because, well the idea is, that they can earn interest off their saved money. Let’s debunk that rationale.
I firstly challenge any one of you to find a savings account that pays much more than 2% interest. Any money that you devote to your savings account will earn 2% interest while your debt continues to increase by 8%. True, it’s better than losing all 8%; you only lose 6%.
Other people will try to tell me that they’ll use some of their money to put in the stock market and are confident they’ll make money that way. Once again, I challenge you to attempt to beat 8% in the stock market. We’re, at best, still coming out of a bad recession and stock prices are still risky. Professional money managers, who play the stock market for a living are lucky if they can get 5-10%, much less just not lose money. Still risky and not helping your 8% cause.
“But, I’m saving up for a house.” Fair enough, both interest rates and home prices are the lowest they’ve been in decades. A investment in real estate is smart. Good luck trying to get a mortgage for your house. Essentially, a mortgage is just another loan attached to your name. Banks give mortgages based on the fact that you’ll be able to pay off your loan. A person with minimal debt vs a person with high levels of student loan debt, which to you looks more likely to pay off the loan in time? If you don’t believe me, head to your local bank and chat with a mortgage lender, they’ll bring you up to speed.
The crux of my argument is that you should use your money in the best way possible. For most of us, the best we can do with our money is pay off our student debt. Saving or investing doesn’t make sense (just yet), because of the higher interest levels of your loans.
Do the math, I’m confident you’ll arrive at the same conclusion I did. For most of us, after establishing an emergency fund (start with 3 months of expenses) we should divert the bulk of our non-spending income to our student debt. If you still doubt me, just try doing this for 6 months. Pay off as much as you can for 6 months and then re-evaluate. I trust that the pennies you would have earned will be dwarfed by the thousands of dollars you’ve paid down!