In light of events happening all over the place (but particularly in Ferguson, MO), I’ve been reminded of an eternal truth: The mind is like a parachute; it functions best when open.
Pretty sure Abraham Lincoln said that.
I’m kidding, of course — “source unknown”, but the truth is that while the social media activists, the media and those fueling the fire of argument on either side are increasing the volume of outcry, it’s difficult to say how much actual benefit that is ultimately bringing. Certainly there are evident problems there, here in Fort Collins, and all over our nation. Perhaps, in fact, some good may eventually come out of this terrible tragedy of a lost life.
But we must also avoid drawing pat conclusions (again, on either side) where facts are murky.
In their excellent recent book, Think Like a Freak, best-selling “Freakonomics” authors Steven Levitt and Stephen Dubner write of the rising phenomenon of dogmatism — and how it significantly hampers our ability to see solutions to problems very clearly.
Although I may only be a tax professional, in my humble opinion, there are some serious problems in our culture. There really is racism. And there also really is danger for honest policemen and women.
But shouting, lecturing, militarizing and browbeating won’t achieve the healing and improvements for which we all wish. While social media can certainly play an important hand in bringing attention to, and opening dialogue on, some of these situations and issues, let’s be careful to maintain a tone with one another that is respectful and open to the validities in others’ thoughts.
In other words, let’s all pour a small bucket of ice water over our heads, regarding some of our cultural hot topics — and be sure we’re listening first and speaking last, shall we?
Now, speaking of open minds … let’s talk about college education. Specifically, how to pay for it.
Judy Meyer’s Big Idea: Pay For College AND Build Wealth?
“He that can have patience can have what he will.” -Benjamin Franklin
The average Fort Collins college student graduates with almost $20,000 in student loans. While this is a daunting sum, it is still possible to build wealth even while paying off student debt. But earning the degree and paying for the degree require two different kinds of smarts. In fact, some students may be better off not taking their parents’ advice on how to get out of debt.
Unlike most types of debt, student loans are usually best when paid as slowly as possible.
Almost all debt is bad debt. But, there are two areas in which this general rule is not as hard-and-fast: home mortgages and student loans. Diligent savers can use these types of debt to their advantage.
Students often assume the best thing to do is to pay off student loans as quickly as possible. The sooner you pay off your loans, the sooner you can start building wealth, or so the thinking goes. But, given the opportunity, which answer should you choose: A) Make extra principal payments on your loan each month, or B) Pay the minimum amount due and save and invest the difference?
The real answer is: it depends. However, as a rule of thumb, the lower the interest rate on your loans, the better off you’ll be just paying the minimum monthly payment and nothing more. Take the extra money you were going to pay on your loan and invest it instead.
The lower the rate of interest on your loan and the higher the average market return, the more it makes sense to invest your extra dollars instead of paying down on your loan. The difference between these two rates is known as the “spread.” If market rate of return is 11% and the interest on your student loan is 4%, then, the “spread” is 7% (11% minus 4%).
Let’s look at two examples. Sally and Brian each have $20,000 in student loans which are to be paid over 10 years at 4% interest. Brian pays his monthly payments of $202 plus $100 extra to retire his debt as quickly as possible. By paying making bigger payments, Brian is able to pay off his debt in just over 6 years. Now, with his debt out of the way, Brian invests the full $302 per month that he had been putting towards his debt. Ten years after graduating, Brian has paid off his school debt and his investments have grown to $16,728.
Sally decides to adopt a different loan repayment strategy. Instead of paying extra on her loans, Sally pays only the minimum amount of $202. She takes the extra $100 per month that she could have been paying toward her debt and invests it. She continues this simple plan for the full life of her loan. Because she makes no extra payments on her loan, she takes the full 10 years to pay off her loan. Now, ten years later, Sally’s loan is finally paid. However, her investments have grown to $21,700, beating Brian’s return by $4,972!
Sally has made more than Brian even though she only paid the minimum balance due on her loan. Instead of making extra payments as Brian did, she invested her money for a longer period of time. And even though Brian was able to retire his debt sooner than Sally, his big monthly investments were unable to catch up with Sally’s early saving. Sally was able to boost her savings by starting early and harnessing the power of compounding interest. In the investing world, this principle is called the ‘time-value’ of money.
However, this model is not ideal for everyone facing student loans. The smaller the spread between your loan interest rate and the average market return, the less appealing this strategy becomes.
Plus, there are other important cases to be made, of course, for working to be debt-free as quickly as possible, as I’ve written about before.
Still, there is one additional reason students should consider paying just the minimum monthly payment on student loans. Student loan interest, like home mortgage interest, is tax deductible (which of course, you KNOW I love!). By allowing you a tax deduction of up to $2,500 for student loan interest, Uncle Sam is, in effect, helping to subsidize the cost of your loan. The faster you pay down principle, the faster you lose your tax deduction, which is one more reason that paying just the minimum may be the best option for some. And, with the savings from your tax deduction, you have more money to invest at higher rates of return.
In order to benefit from this loan repayment strategy, you must save and invest your money. If you don’t invest the extra money (and you simply spend it), you would have been better off putting your extra dollars toward the repayment of your loan. But before deciding on a loan repayment strategy that’s right for you, be sure to take care of the following basics first.
Learn about your loans. Many student loans allow for a 6-9 month grace period before loan repayment begins. During this time, your loans may be charged a lower rate of interest. Consider consolidating your loans and locking in your interest rate while your loans are at a lower rate. This may not only help keep the cost of borrowing lower, but it will mean you only have to write one check per month.
Establish an emergency fund. You should have enough money in your emergency fund to cover three months of expenses. This money should be used only in the case of emergencies, and not for those late-night runs to Taco Bell.
Pay off your credit card. It’s estimated that college graduates carry an average of $2,500 in credit card debt. Most credit cards have very high interest costs. Be sure that you are not numbered amongst that statistical class. You cannot build wealth while paying 19% interest on your credit card purchases. Do not begin investing until you have an emergency fund and have eliminated your credit card debt.
Sign up for free money. If you have just started a new job, check to see what type of retirement benefits your company offers. Many companies will match your contributions dollar-for-dollar up to a certain percent of your pay. In other words, you get free money if you invest in the company retirement plan. Make every effort to contribute enough to get the full match. By doing so, you are, in essence, receiving a 100% return on your money. And, don’t assume you are too young to save for retirement. By saving now, and harnessing the power of compounding interest, you’ll have enough to retire long before most of your friends. Remember the time-value of money!
Contribute to a Roth IRA. Once you’ve built up an emergency fund, paid off your credit cards, and taken advantage of any free money available through your employer, make every effort to invest any remaining dollars in a Roth IRA. A Roth IRA is the ideal place to put those extra dollars you were otherwise going to apply to your student loan principle.
Building wealth takes time. But by starting early, you’ll be sure to make the grade.
And, as always, we here at Judith E Meyer CPA are here to help. Thanks for listening.
Judith E Meyer CPA