Don't Focus on Rapidly Paying Off Student Debt
Debt payoff strategies abound on the internet, and many mainstream financial gurus have built an empire on the common-sense approach to focus your financial efforts first on paying off your debt. While credit card debt, auto loans, and even mortgages are all targets of these strategies, one of the newest and most common targets is the student loan debt which many millenials are graduating with.
Joshua Escalante Troesh is ranked the #1 advisor nationally on Investopedia’s Advisor Insights.
But The Math Doesn’t Support This Advice
Unfortunately, math and common sense don't always align. Before you devote all of your extra income to paying off debt, make sure to do the math on how the debt payoff strategy might impact your ability to save for your future. No matter how appealing the idea of being free from debt might be, taking a more comprehensive approach will likely put you in a stronger financial position when considering not just your debt payoff goals but also your other goals, like retirement or buying a home.
To illustrate this idea, the following is the mathematical reality of two strategies represented by the stories of two recent college graduates - Payoff Pat and Comprehensive Corey. Both are twenty-five years old, just graduated from college with $50,000 in student loan debt, and both have landed jobs paying $50,000 per year.
OTHER KEY FACTORS USED FOR THE CALCULATIONS
4.45% student loan interest (Current Federal rate)
2% High-yield savings account (Current Bankrate.com rate)
3% company match on 401(k) contributions (lowest match a company is able to offer to avoid the costly and complicated non-discrimination testing the IRS requires)
8% retirement portfolio returns (assumes an 80/20 equity to bond allocations)
22% Federal tax bracket (current tax rate for 2019)
8% other withholdings (includes state taxes, FICA, SDI, and others)
$2,008 in monthly expenses
Both have $909 to devote toward improving their finances.
Both are starting with $1,000 in savings
0% Inflation - Inflation will cause the numbers to be different, but will impact both Pat and Corey in a similar way. As a result, inflation is not factored into the equation.
Payoff Pat
Pat bought a financial expert's book, which advocated focusing all extra money on one goal at a time; paying off all debt first, then saving everything toward an emergency fund, and finally investing toward retirement.
The simplicity of the book's strategy and the allure of living debt free appealed to Pat. So Pat took all $909 of extra income and devoted it toward paying off student loan debt. Additionally, all of the money Pat saved on taxes for their student loan also went toward paying off their debt.
Comprehensive Corey
Corey was overwhelmed by the decision and talked with a fiduciary and fee-only financial planner. The planner recommended Corey go on a 25-year repayment plan for their student loans, which set the payment at $249.51. The planner also recommended Corey contribute $125 each month to the company 401(k) - just enough to get the company 3% match. With the remaining $534.41 per month, the planner recommended Cory save in a high-yield savings account to build an emergency fund.
5 Years Later
Pat's Net Worth: $1,000
Within 5 years Pat had completely paid off the student loan, and can now focus on contributing to their emergency fund. Once the fund is build, Pat can then devote everything to their 401(k). At the 5 year mark, Pat has $0 in student loan debt, but also has $0 in their retirement account and $1,000 in their savings account.
Corey's Net Worth: $9,216
Corey, on the other hand, still has $43,136 in student loan debt. Corey also has $18,369 in their retirement account and another $33,983 in the high-yield savings account.
Pat’s Additional Risk
In addition to having significantly less net worth than Corey, Pat also was subject to significantly more risk during these 5 years. Because Pat only had $1,000 in savings, any job loss or unexpected expense would have likely resulted in additional debt and stress. What’s worse, it’s likely a job loss or an emergency costing more than $1,000 could send Pat into high-interest credit card or personal loan debt.
Corey can easily pay cash for emergencies
Corey, on the other hand, was saving more than $6,000 each year into an emergency fund. There was significant savings available to handle any unexpected expense or a job loss. In just the first six month, Corey has enough savings to pay their student loans for over a year if they lose their job. By year five, Corey has enough savings to replace their take-home pay for over a year. Definitely enough time to find a new job and get back on track.
Corey’s plan can handle the unexpected better than Pat’s
While it seams like Pat's strategy of paying off the debt is the 'safer' alternative, this is only true once Pat completely pays off the student loans. Pat actually took a significant unnecessary risk by devoting all of their extra income toward paying off the debt. Additionally, even though Pat can now devote all of their money to building an emergency fund, it will take Pat another 38 months to reach the value of Corey's emergency fund.
Savings at Retirement
The argument often made to these number is Pat now will be able to save much more into their retirement account than Corey. Pat will be able to catch up to Corey's head start. While this might make "common sense," the actual math doesn't work out. Both Pat and Corey are now age 30, and have 35 years until retirement. Here is what each of their retirement balances grow to when they turn 65.
Pat's Retirement Balance: $1,794,819
Beginning at year 5, Pat devotes the entire $909 toward their emergency fund. A short three years later, Pat has built an equivalent emergency fund to Corey. At that point, Pat devotes all $909 toward their retirement account, earning the 3% match and an average return of 8% over their 32-year period. The resulting account balance is nearly $1.8 million dollars.
Corey's Retirement Balance: $2,459,041
Corey's retirement balance is a little more difficult to calculate. Corey already has $18k in their retirement account. Corey is finished with their emergency fund after year five, but still has twenty years of student loan payments to go. It is not until Corey pays off the student loan that they can devote the full $909 to retirement. As a result, three calculations are needed to figure out Corey's final balance.
Value of First 5 Years Retirement Savings - $299K
The first calculation is how much Corey's year 5 retirement balance ($18,369) will grow to in 35 years. With the same 8% return, this money will be worth $299,281 at retirement.
Value of Next 20 Years Retirement Savings - $1.8 Mil
The second calculation is how much Corey will be able to contribute to retirement until they pay off their student loans. Remember, Corey still has a $250 student loan payment. As a result, Cory can only contribute $659.41 monthly to their retirement account while paying the student loan. The fact Corey can begin these lower contributions immediately, while Pat had to wait 38 months to build their emergency fund, still leaves Corey with more money at retirement; $1,801,638 to be exact.
Value of Last 15 Years Retirement Savings - $358k
Finally, we have to calculate the contributions Corey can make during their last 15 years of retirement when the student loan is finally paid off. At $909 contributed monthly, this portion of their retirement balance will grow to $358,122.
In total, Corey accumulates $2,459,041 for retirement.
Why Corey has $650K More Money at Retirement than Pat
Corey has so much more money than Pat simply because Corey began investing for retirement earlier. Pat not only loses out on five years of the company's 401(k) match, but also loses out on nearly 8 years of compounding (5 years to pay off the student loan plus 3 years to build an emergency fund).
EVEN WITHOUT A company MATCH, COREY WINS — Cory has $400k more
Having more years of a company match obviously helps Corey, but what if Corey’s and Pat’s companies don’t offer a retirement plan or there is no match? If we remove the match, Corey still comes out ahead by investing on their own in an IRA (Individual Retirement Account). Without a match, Corey ends up with $1,979,411 while Pat ends up with $1,577,820. Corey still has $400k more in their retirement account.
Don't Let Student Loans Stop You
The moral of the story is twofold: (1) Math is important. (2) There is an incredible cost to focusing on a single financial goal at a time. In the case of Pat and Corey, it cost Pat well over a half million dollars.
When considering your financial plan, focus on a comprehensive view of your overall goals. And make sure to do the math on the alternatives so you know the true costs and benefits of different strategies.
If you’d like help making the most of your finances, we offer a Financial Launch program designed specifically for young professionals. Launch includes access to a sophisticated financial planning platform and personal guidance from your own fiduciary financial planner.