If you are like most professionals, you graduated with over $100,000 in student loans. While that debt may feel like a monkey on your back, it is well worth it. Unlike credit card debt which is used to fund consumption, your student loans financed your education and training, and was as an investment in your career. Not only that, but it was also like free money in a period when you weren’t earning any. Now you are earning money and one of the most commonly asked questions I get is “should I pay off my student loans?” The short answer is that it depends on whether you are making the decision emotionally or purely from a financial perspective. Here are some things to consider before paying down your student loan.
Money Loses Value
Inflation is the erosion of the value of the dollar over time. We have all heard someone say “I remember when a new car cost…” Inflation is the reason why it cost $5 to see a movie when you were 18, but now it costs $12; or why $100 just doesn’t seem to buy as much as it did 10 years ago. If your loan is on a fixed-rate, inflation is your friend. Your fixed loan payment does not change for the duration of the loan, but the value of that payment decreases over time. For example, if your current loan payment is $800 per month, in 10 years, the real cost of that loan payment would be equal to $595 assuming a 3 percent inflation (see calculation below). Hence the purchasing power of that $800 has declined in that 10 year period to just $595. If the rate of inflation is higher than your fixed interest rate, you are essentially coming out ahead every year.
History Doesn’t Lie
Most current home buyers would cringe at a 5 percent home loan, but it wasn’t that long ago that 8 percent was the average. In fact, in 1981, the average mortgage rate was 16.63 (www.freddiemac.com)! So historically speaking, interest rates are at all time lows. Interest rates on student loans are also at historical rates. No one knows if interest rates will ever reach double digits again, but markets do tend to revert to their historical mean. If you currently have a student loan with a very low fixed interest rate, it makes more economic sense to pay only the minimum payments because of the low fixes rate and because of inflation.
For a variety of reasons, some people have an aversion to debt – maybe you grew up seeing your parent’s worry about debt, or maybe your grandparents who lived through the Great Depression influenced you. Whatever the reason, if you are emotionally debt adverse, then it makes sense for you to aggressively pay down your debt, even if it’s financially prudent to pay only the minimum. If you can’t sleep at night worrying about your student loans, then it’s probably wise to start paying down your debt early.
The conventional wisdom is to pay off debt as quickly as possible and that all debt is bad. But as illustrated above, there is such a thing as good debt and it doesn’t always make sense to pay it off early. Yes, credit cards are generally considered bad debt, but student loans are an investment in your future earnings potential and is deemed good debt. For those who approach student loans from a strictly financial perspective, now is not the time to pay-off your student loans.