All you read is how people have paid off their student loans early. They beam with pride at their financial prowess. They write books about it! Dave Ramsey is their god!!! Let’s think about this. You take a student loan for a reason. The reason is to multiply your prospective lifetime income potential. You go to college and you decide to major in biology. You’re not that great at math but OK, and chemistry is hard, and physics fergitaboutit. You come out of college basically qualified to be a bio high school teacher @ 50K/yr or something. Not a bad job, union, benefits, pension after 30 years, you’re 22 that means retirement at 52, summers off. You meet Miss Cathcart who teaches computer coding at the same high school same 50K and terms. You get married and live a great life. Out of that 100K you saved 20K/yr and over 30 years your 60/40 returned 6% on the average and you have 1.6M in the bank and a pension. You retire at 100K/yr the pension pays half and the portfolio pays the other half. You die at 92 40 years in the future having spent 4.2M from your pension/portfolio combination. Your total earnings need for your life therefore (not counting taxes) is 100K x 30 yrs (3M) plus 4.2M or 7.2M. How did you manage such a feat on 100K/yr x 30 yrs? The answer is leverage. Instead of spending money you bought property also known as stocks. The market went up over 30 years and you levered that property a from 20K x 30 yr principal donation (600K) into a 4.2M lifetime bonanza. Such is the power of capitalism and risk (another name for leverage). This future is just how it worked out, it could have gone the other way where a long bad SOR early in the 40 years of retirement and the risk could have eaten part of your 40 year nest egg or killed it altogether.
You have bigger plans. You manage to get into med school with your bio degree signing up for an additional 10 years of schooling, going into debt for 200K . So now you’re 32, 200K in debt but you have a job that pays 300K/yr. 300K however has a lot of extra taxes etc associated (soak the rich) so you really make 225K. During the course of 10 years guy 1 bought a house, has a kid, has been contributing to a college fund. His portfolio is worth 300K and his 15 year house loan is 2/3 paid off.
You have 200K in debt a 225K job no house, no pension, no portfolio, you married a nurse and have a kid but have yet to address college. Dave friggin Ramsey says pay off your loan!! is that wise? Your loan is a known known. It has a term say 10 years, and a payment schedule in 10 years depending on the interest you will pay back 200K plus some interest say 50K for a total of 250K and the payback over each year may be 25K/yr. What is that 25K? It’s the cost of doing business. It’s the cost you pay for multiplying your ability to make 200K/yr instead of 50K per year, but you also lost 10 years of portfolio growth and pension and college funding. What does paying off your debt 5 years early buy you? You will pay a little less interest, you will be 5 years older. You still will not have really started saving enough to catch up with guy 1 or pay for college. You bought too much house, too much car, ’cause you’re a doctor. At 37 can you catch up? At 15 years in guy 1 is just shy of 500K in the portfolio. You now start saving aggressively but you have to aggressively fund college and fund that big damn house as well. If you invest 65K/ yr for 15 years you will almost catch up to guy 1’s portfolio so you are now 52. Wait a minute guy 1 has a pension! That means you need not 1.6M but 3.2M at age 52 to have enough to generate 4.2M you need till you die. Pony up 130K/yr to get even
Instead of putting all your money in the known known of a student loan you would have been far wiser to expose that money you spent paying down the loan early to the long term risk necessary to support you to age 92. The loan is a strictly defined nuisance in terms of your life long risk and any extra money you put into paying that off early is money you do NOT put toward a potential 60 years of growth you could have had. But it’s not even a nuisance since it is the tool you used to buy your way into your career. You would be the first one to criticize someone for buying a depreciating asset like a BMW but a loan is just a depreciating fixed term liability wasting too much assets on that is just as dumb as buying a BMW. OH but I saved 20K in interest!! At 32 you have 60 years left and at 37 you have 55 years left that 20K you “saved” could have become 659K in 60 years instead it became 493K without those extra 5 years of growth. That 20K and the “good feeling” of not being in debt you bought with it at age 32 cost you 150K over the course. Notice what occurred, what drove you. It was a feeling and a narrative somebody sold you. You hate debt!!! you say self righteously! Debt doesn’t hate you, neither dose it love you. It’s a tool. A known known. Something you can completely plan for and optimize relative to the other features of your financial life. It’s leverage, a force multiplier.
When I retired Obama was president and Clinton was running. The government had a program to take out some money from house equity, and as a Navy vet I could extract some big dough from my equity and put it in the market. You had to do it while you had a W2 happening. I considered it and decided against because the economy was doing less than 2%. Too much risk. The economy was a wreck, like a one lung COPDer with cor pulmonale and a peg leg. That guy ain’t climbing any stairs despite what CNN says. The pathology is too obvious to ignore. The program expired and so did my W2. Trump won, I shoulda!
4 Replies to “Why Paying Off Your Student Loan Early is Like Buying a BMW.”
It is a valid stance on the debt payoff vs investment debate. Most of the times you come out ahead with investing unless you happen to invest at a bad time and the markets crash.
For me it was a lot of psychology involved. Just got out of a divorce and something clicked that I didn’t want to have debt weigh me down anymore.
I knew I was tomorrow’s cheaper valued dollars with more expensive today’s dollars but I still went through with it. No regrets even though I know I left some money on the table. I have now been concentrating on investing and piling all my cash at it
My point is not to accuse anybody’s decision, just to try to bring a little light to the darkness. You are correct to say it’s psychological, in fact it’s neurological. Risk avoidance operates at a 4:1 greater probability in choice, that means given only drive states like turmoil you will choose the incorrect risk avoidance 4 times more often than the correct risk. It turns out the cortex has a weak control over risk avoidance and you will do the risk avoidance even if you work through the correct logic. I didn’t buy any leverage on my home even though I likely should have and I was completely aware of the advantages. It’s a survival behavior hard wired in at a sub-cortical level and is very well studied. Yet Dave Ramsey has become a multi multi millionaire selling risk avoidance like a religion. Dave Ramsey has his point, if your life is so leveraged that you are living off 18% credit cards. If you are at the beginning of a 7 million dollar 60 or 70 year run a couple hundred grand that has a well defined risk and payoff period of 10 years is not relevant. It is the price of admission and having that debt and disposing of that debt while planting green shoots in parallel with resolving the debt that will grow into trees is the proper vision. It’s the same as focusing on 10bp or 2bp mutual fund cost or the PhD (pile higher and deeper) approach to obtaining diversity at some point you loose focus. I’ve never really read a blog post that recommends not paying off your debt early, but never any support for that. Many times they will even acknowledge it’s a wrong move and do it anyway because it’s hard wired into the brain. This is something of the problem with FIRE blogs and DIY, so much advice so little evidence it’s useful.
In fact in a down market, that is precisely the time to invest in stocks, but one won’t do that because of risk avoidance and that’s the lesson.
Psychology is every bit as important as the math in success, no matter how compelling the latter.
Logic and humanity have only a small area of overlap on their Venn diagrams, and at certain moments I’m positive it’s shrinking.
After a while it’s like bird watching to see the pageant of humanity parade by in a display of brilliant neuroses. Such plumage I never could have imagined!
Psychology is something open to modification. It turns out the risk avoidance system is not very bright but is very fast and very dominant. It takes a lot of effort to tame it enough to jump out of a perfectly good airplane. The cortex effects weak control on risk avoidance while risk avoidance exerts profound control on the cortex. Understanding that is understanding the true psychology as in neurobiology. Improving a outcome is dependent on making choices that have a higher probability of a positive result and if you get enough positive improvements along the way baring disaster you win. In the 51/49 risk case, played long enough with correct risk management you can not loose. It’s why Vegas casino’s don’t allow card counters. You can pay off your loan if you want and purchase that psychological “well being” but it’s worthwhile understanding the cost of your purchase is real dollars and cents. People will loose their minds over paying 20bp to an AUM but think nothing of throwing away 10 years of growth