Should I use put extra money toward paying off my student loans or investing in an index fund?

Question

The following is what I've written so far to examine and try to solve this dilemma I'm in of whether to put my extra money toward my student loan debt or invest it, which I'll be publishing on my site (but this is more for my own determination). I've done the best job I can quantifying the differences in interest and time frame. Given this data, is the answer clear? I've done some research on historical investment returns and some expected returns published on this page.

I'm especially confused about whether/how I would compare inflation—should I be comparing with real returns (inflation adjusted), or would this not matter for the sake of comparison since the money I'd be putting toward debt would be affected by inflation the same way....?

I would probably be investing in a passive mutual fund or ETF with mostly stocks and some bonds, maybe 70% stocks and 30% bonds (I'm 25).

Thanks in advance for any tips.

The Decision

The decision of whether to pay off your student loans or use that money to invest for potentially greater overall returns could have an immense impact on your future financial state, and thus should not be taken lightly.

I myself am struggling to make this decision. Over the past 20 months I've managed to pay off ~23k of ~53k in federal student loan debt. I chose not to consolidate so I could strategically target the accounts off the ones with the highest interest rates first (opposite of the mega-popular debt snowball plan advocated by Dave Ramsey and his minions), which has saved me a lot of money. 

But now that I have my two accounts with the highest interest (6.55% after a 0.25% autopay discount) paid off—for which it was a no-brainer to extinguish as quickly as possible—the interest rates of the remaining accounts seem comparable to returns on long-term investing.

Income and Expenses

My after-tax monthly income is ~$2,510, or ~$30,120k annually. 

For the purpose of context, my monthly fixed expenses total $1208 ($710 in rent, $378 in student loan minimum payments, a $100 bus pass, and a $20 cellphone bill), and my variable expenses for necessities total ~$200 per month (~$100 in food and ~$100 in utilities).  I'll assume a $100 average monthly expense for everything else (clothes, home items, going out to the movies, travel, etc.).

Thus, I have ~$1000 per month to do decide what to do with. (Health and dental insurance are paid in full by my employer, which is why those expenses are not factored in. Also, my food expenses are relatively low because I pick up food from my local food bank each week.)

Remaining Student Loan Balances

Here are my current student loan account balances and required monthly minimum payments. By paying just the minimum payment, I'd pay each off in 8.4 years, due to my originally choosing a 10-year repayment plan.

• $6530 at 4.41%, $77.10/month.
• $4900 at 4.41%, $57.93/month.
• $6,650 at 3.61%, $75.92/month.
• $4,980 at 3.61%, $56.88/month.
• $4,950 at 3.15%, $55.54/month.
• $4,870 at 3.15%, $54.61/month.

The minimum payments for my student loans total $378 per month.

Loan Payments

I plugged these numbers along with my total budget for student loan payments (including the $378 in required minimum payments) to a handy calculator (http://undebt.it/debt-snowball-calculator.php) that determines when I'd be done paying off my loans and the total interest I'd accrue by applying my monthly payments using the debt avalanche method, i.e., applying all extra available money toward loans with the highest interest rate.

In that scenario, I'll be done paying off my student loans in May 2019, and my total interest cost would be $1,258. By paying just the minimums, I'd be student loan debt-free in October 2025 and my total interest would be $5,542—an additional $4,284. 

Incidentally, if I used the popular (and much-loathed-by-myself) debt snowball method of applying all extra money toward the loans with the lowest total balance, I'd be done paying off the loans during the same month, but I would have paid an additional $111 in interest. I imagined the difference to be more extreme, but I'm not delusional enough to take that route (in other words, the irrational motivation of getting rid of accounts more quickly would not outweigh the cost of paying more in interest).

Tax Impact

Payment of student loan interest may make one eligible for a deduction of taxable income.  You may deduct a maximum of $2,500 of both required and additional interest payments. Your deduction eligibility is gradually reduced and eventually eliminated by phaseout as your modified adjusted gross income (MAGI) increases to the annual limit for your filing status.

Your MAGI is your adjusted gross income, your gross income minus certain deductions, with certain items that weren't used to calculate both your gross income and adjusted gross income added. Examples of things that may be added include tax-exempt interest, tax-exempt foreign-earned income, and deductions for IRA contributions and costs of higher education.

Your MAGI limit depends on your tax bracket. In my case, I'm in the 15% tax bracket and unmarried, making my limit is $80,000; with my measly salary I definitely don't have to worry about losing my eligibility for the deduction.

Let's take that additional $4,284 I'd be paying if I began paying just the monthly minimums across my loans. In that scenario, it would take me 101 months instead of the 24 months in the scenario in which I'd apply my spare $1,000 per month toward my student loans in the debt avalanche fashion; that's an additional 77 months (6.4 years). That's an extra $56 per month, or $667 per year, that I could deduct from my taxable income. Since I'm in the 15% tax bracket, that's an additional $100 in tax savings each year in excess of those of the 'all-in debt payoff' scenario. Since it would take me an additional 6.4 years, that would be $640 I could deduct from my total extra interest cost, making it $3,644. 

The Question

The question now is: Would the returns of putting that extra $1,000 per month for those extra 77 months toward investing be worth more than that $3,644?

When comparing the overall return of paying off the loans and investing, the returns of paying off loans are relatively straightforward (my student loan interest rates are fixed, as are all of those for federal student loans—if mine were variable, things would be a lot more convoluted). In the the case of investing, these factors should be considered when estimating returns:

• What are the likely after-tax returns?
• What are the likely after-inflation returns of investing?
• What are the after-fee returns of investing?

For student loans, the amount I'm paying off will be affected by inflation, so for the purpose of this comparison, inflation is not influential. And obviously, fees don't apply, so that's a sole consideration of investing. 

Answer 1

First, I'd like to congratulate you on your financial discipline in paying off your loans and living well within your means. I have friends who make more than twice your salary with similar debt obligations, and they barely scrape by month to month.

If we combine your student loan debt and unallocated income each month, we get about $1,350. You say that $378 per month is the minimum payment for your loans, which have an average interest rate of about 3.5%. Thus, you have about $1,350 a month to "invest."

Making your loan payments is basically the same as investing with the same return as the loan interest rate, when it comes down to it. An interest rate of 3.5% is...not great, all things considered, and barely above inflation. However, that's a guaranteed return of 3.5%, more or less like a bond. As noted previously, the stock market historically averages 10% before inflation over the long run.

The US stock market is right around its historic high at this point (DJIA is at 20,700 today, April 6th, 2017 - historic high hit just over 21,000 on March 1, 2017). Obviously, no one can predict the future, but I get the feeling that a market correction may be in order, especially depending on how things go in Washington in the next weeks or months. If that's the case (again, we have no way of knowing if it is), you'd be foolish to invest heavily in any stocks at this point.

What I would do, given your situation, is invest the $1,350/month in a "portfolio" that's 50/50 stocks and "bonds," where the bonds here are your student loans. Here, you have a guaranteed return of ~3.5% on the bond portion, and you can still hedge the other 50% on stocks continuing their run (and also benefiting from dividends, capital gains, etc. over time). I would apply the extra loan payments to the highest-interest loan first, paying only the minimum to the others. Once the highest-interest loan is paid off, move onto the next one.

Once you have all your loans paid off, your portfolio will be pretty much 100% stocks, at which point you may want to add in some actual bonds (say a 90/10 or 80/20 split, depending on what you want). I'm assuming you're pretty young, so you still have plenty of time to let the magic of compounding interest do its work, even if you happen to get into the market right before it drops (well, that, and the fact that you won't really have much invested anyway).

Again, let me stress that neither I nor anyone else has any way of knowing what will happen with the market - I'm just stating my opinion and what my course of action would be if I were in your shoes.

Answer 2

From a purely financial standpoint (psychology aside) the choice between paying off debt and investing on risky investments boils down to a comparison of risk and reward. Yes, on average the stock market has risen an average of 10% (give or take) per year, but the yearly returns on the S&P 500 have ranged from a high of 37.6% in 1995 to a low of -37% in 2008. So there's a good chance that your investment in index funds will get a better return than the guaranteed return of paying off the loan, but it's not certain, and you might end up much worse. You could even calculate a rough probability of coming out better with some reasonable assumptions (e.g. if you assume that returns are normally distributed, which historically they're not), but your chances are probably around 30% that you'll end up worse off in one year (your odds are better the longer your investment horizon is). If you can tolerate (meaning you have both the desire and the ability to take) that risk, then you might come out ahead.

The non-financial factors, however - the psychology of debt, the drain on discretionary cash flow, etc. cannot be dismissed as "irrational". Paying off debt feels good. Yes, finance purists disagree with Dave Ramsey and his approaches, but you cannot deny the problems that debt causes millions of households (both consumer debt and student loan debt as well). If that makes them mindless "minions" because they follow a plan that worked for them then so be it. (disclosure - I am a listener and a fan but don't agree 100% with him)

Answer 3

Yes, it's a risk. To put it in perspective, If we look at the data for S&P returns since 1871, we get a CAGR of 10.72%. But, that comes with a SDev (Standard deviation) of 18.67%. This results in 53 of the 146 years returning less than 4%.

Now if we repeat the exercise over rolling 8 year periods, the CAGR drops to 9.22%, but the SDev drops to 5.74%. This results in just 31 of the 139 periods returning less than 4%. On the flip side, 26 periods had an 8 year return of over 15% CAGR.

From the anti-DS article you linked, I see that you like a good analogy. For me, the returns of the S&P over the long term are like going to Vegas, and finding that after you run the math of their craps (dice rolling game) you find the expected return is 10%. You can still lose on a given roll. But over a series of a larger number of rolls, you're far ahead.

To D Stanley - I agree that returns are not quite normal, but they are not so far off. Of the 139 rolling returns, we'd expect about 68% or 95 results to be 1 SDev away. We get 88 returns +/-1SDev. 2 SDevs? We'd expect only 5% to lie outside this range, and in fact, I only get one result on the low side and 4 on the high side, 5 results vs the 7 total we'd expect. The results are a bit better (more profitable) than the Normal Bell Curve fit would suggest.

Answer 4

Not all debt is bad. If it carries a reasonable interest rate, you don't need to clear it immediately.

As for investing in an index fund, they're an affordable, easy way to spread your money over various assets. However, asset allocation is just one of many investment strategies. Ideally, you want to invest according to your goals, tax situation, and risk tolerance. You want a portfolio that dynamically allocates to various investment strategies, both beta and alpha, according to changing market conditions. Most importantly, you want systematic risk management for every aspect of your investments.