Student Loans And The Philosophy Of Debt

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A reader wrote to me recently stating that she had about $40,000 in student loan debt at 4% (she locked in in late 2002 when the rates were in the basement) and she couldn’t decide if she should be making extra payments on the debt. My advice to her was to figure out how much she could afford for payments each month, then just make the minimum payment and put the remainder in a savings account that earns 5% or better. She wrote back with the following:

This is why personal finance doesn’t make sense to me. Different people give different advice all the time. I listened to Dave Ramsey the other day and someone called in with almost the same question and he told them to pay off the debt and get debt free. I think you both believe that you’re right, but it just confuses people.

The big problem is that you’re talking about two somewhat different personal finance philosophies. I agree with a lot of what Dave has to say, but Dave holds a central philosophy that all debt is always bad and you should seek to be debt free before doing anything else. I don’t necessarily agree with that philosophy in some cases, and one of them is a low-interest debt brought on for a good reason like getting an education.

Here are a few of the more common philosophies that I’ve seen roaming around:

The “all debt is bad” philosophy As I noted above, this is the philosophy that Dave Ramsey promotes. The idea behind it is that debt means you’re effectively a money slave to someone else. This plan removes debt quite well, but can leave you very vulnerable if you do it too vigorously.

The “only high interest debt is bad” philosophy I find myself in this group. Low interest debt, like the student loan debt above, should be left alone and you should only avoid high interest debt (right now, anything over 7% or so); instead, you should be building up a big emergency fund and a fund to buy more expensive things (like cars) with cash. This plan offers breathing room and security, but does leave some debt in place.

The “leverage is the way to get ahead” philosophy This is the general philosphy that folks like Robert Kiyosaki promotes. Basically, debt is great as long as it puts you in a situation to make a profit, but it does require some business sense and a plan.

Which one is right? I honestly can’t tell you that. It depends on your temperment and your beliefs, mostly. I’m a pretty big fan of a big emergency fund and leaving low interest debts alone, but I can see the logic behind other philosophies and I can easily understand why people might subscribe to them.

All of those philosophies have clear advantages and disadvantages and you’re not “wrong” by choosing one over the other as long as you’ve spent the time thinking about them and figuring out which one rings true for you. Some people will offer compelling arguments why one is better than the other, but quite often they rely on focusing on one particular attribute of the philosophy. Ramsey’s plan, for example, can show massive debt eliminations quickly, but what sort of security against a major disaster did they have while doing it? Kiyosaki’s plan can show some huge profit, but what about the losses from people who didn’t see their small business succeed?

Listen to your heart. Your mind might not know all of the answers, but your heart will often point you towards the plan that’s right for you. Remember, the goal with all of these plans is to ensure that you’re in a better financial state tomorrow than you are today, and for the most part, they’ll all do that quite well.

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37 thoughts on “Student Loans And The Philosophy Of Debt

  1. An interesting summation of the various financial philosophies. For me, I feel that the Ramsey method leaves a person debt free and cash poor thus open to financial ruin should an unforeseen even occur during the time they are attempting to pay off their debt. Imagine having no debt and a fully paid off home but unable to pay a hospital bill because all your money is tied to your home which you can’t refinance because your injury cost you your job.

    Kiyosaki’s method is equally dangerous, but in the other direction. Leaving you with your money in hand, but exposed to risk which could remove all your ready cash and then some if one of your larger investments goes sour. I point you towards Casey Serin and http://www.iamfacingforeclosure.com/ for reference.

    My philosophy is similar to Trent’s in that I believe some debt, WHEN USED PROPERLY, is good. This includes educational debt and calculated leverage debt (like buying investment properties or other investments). To ME this method works best, but I know many people in my life for whom my philosophy would NOT work. For them I suggest other methods and I take the time to explain the reasoning and sometimes I even gift them a book to help them better understand.

    All of this is to say that I agree with Trent that what financial advice YOU find the most useful will ALWAYS be a personal choice and not a mathematical one. Decide what your personal risk/reward level is and go from there.

  2. An oft-ignored rebuttal to the “all debt is bad” argument – without debt, you have no credit history. It sucks that that’s the way the world works, but the fact is, that’s the way the world works. So if you ever find yourself needing credit for something, you won’t be in a position to get it, or at least not on favorable terms, because you have no credit history.

  3. My Dad is a CFO and his advice has always been to keep debts that are below the average market investment return (so below 6-8%). Instead of making extra payments, invest that money in something like the Vanguard 500 (once you have a 6 month emergency fund) so your money will grow over time.

    A savings account is a good idea, but you have to remember that they can be as low as 1%. Over time, the market gets much better returns than a savings account.

    Plus, the interest on her student loan is tax deductible (unless she meets the income cap), so she can reduce her taxes for several more years by not paying it off early.

    Furthermore, if she really wants to get ahead financially, she can invest those extra payments in a 401K or Roth IRA rather than a taxable account.

  4. Is there a web calculator somewhere that helps you figure out what your actual student loan interest rate really is if you deduct your student loan interst on your tax return?

    ex. Say your student loan is $10,000 at 5% interest? If you paid $500 in interest and deduct it on your taxes, what is your “real” interest rate on the student loan? Is it really something like 4.5%? ($500 being in the first 10% bracket)

  5. But isn’t School Debt Interest considered to be a direct Tax Deduction? So ultimately even if you’re paying 8% on the loans the extra deduction makes the rate closer to 6%, so the liability on student loan debt is actually even lower than stated.

    Correct me if I’m wrong, but as long as you don’t have more than $2500 a year in interest then is there even a reason to pay it off quickly?

  6. One of the worst things about student loan debt is they are an unsecured loan. It doesn’t have the high interest rate that other unsecured loans do, but the only thing backing the loan is your promise to pay it off.

    Dave Ramsey is right in the fact that you are still a ‘slave’ to that debt. The debt isn’t something that can be immediately sold to satisfy the debt, the debt is something intangible that you hold – your education.

    If I lost my job, and my wife lost hers, and we had no way to pay the bills other than our emergency fund, we could sell the house and then we wouldn’t owe anybody anything. But if the same thing happened and I had student loan debt, I could sell everything I owned and the person who held the debt still could claim I owe them something – and they would be correct.

    The math behind saving the money is sound. But that is still money leaving your checking account every month. I disagree with Trent here. Pay off the student loan.

  7. I clearly fall into the “only high is bad” philosophy. I rolled a rather big debt into a 0% for life of balance card offer several years ago. Think I’m going to pay more than minimum? Why on Earth would I want to do that?!?!

    I also argued recently in an article on my own blog against paying down your mortgage if you have a short term and attractive rate already in favor of investing in your 401-K.

    Remember that you pay off debts with AFTER-TAX money and you invest in your 401-K with PRE-TAX money!

  8. Great post, Trent. I totally understand the person you quoted, but personal finance is about finding out what works for you, personally. Just like losing weight – there are many different types of weight loss programs that will help you, but only if you follow them! A lot of finding what works is trial and error.

    For me, your site has helped tremendously. Since my values and temperament seem to align with yours, I am comfortable looking to your choices as examples to me. Of course I evaluate them within the context of my own experience, but on the whole, what you have to say is largely applicable. I still have about 12,000 worth of credit card debt to tackle (out of $20,000 originally), which I had consolidated before I found your site. Now, I just pay one (rather large) payment each month towards paying that down – the interest rates are all down to 8-9% on the cards. For the past two years I have been doing this and completely living within my means, without using credit at all. I also got rid of my car, which I didn’t need – THAT has saved so much money!

    Recently, I have started making a little more money and want to accelerate paying this debt off. But, thanks to your site, I will take 2 months to build up a $1000 emergency fund before starting to make extra payments on the debt. This will protect me from resorting to using credit when something unforeseen occurs. I feel great about my plan and my ability to follow through on it. Within two years, I can see my husband and I really being able to start saving for a down payment on home, which is our dream.

  9. My personal belief is that all debt is bad, unless you can prove otherwise ( guilty until proven innocent if you will ). Sometimes there is “good” debt, but too much “good” debt can be just as bad.

  10. All debt is bad. But debt has positive effects. Without debt, much of our economy would not work. But debt is bad because circumstances change. If you had enough invested at 5% to pay minimum payments on a 4% loan, your tax rate may go up. I read this morning that President Bush extended the reach of the so-called “kiddie tax” to more young people, taxing more of the money they could use for college. On the flip side, I do not think most people recall what their taxes were before Bush’s tax cuts. I remember. It was a significant amount of money over a year. Democrats want to “roll back” these cuts. Whether you think that is good or bad, you will need to adjust to having less money in your pocket to spend, save, or invest as you please.

    Prices change. Interest rates change on new debt. You may have your pay or your job cut. Debt must be paid, though, regardless of circumstances. In that sense, all debt is bad.

  11. For me, this is largely a theoretical question–I don’t actually have any debt. Nevertheless, part of the reason I don’t have, say, any credit card debt is because the whole idea of debt just feels profoundly uncomfortable to me. I don’t like the idea that a part of my future earnings is already spent. I do use a credit card, but the thought of using it to buy things I couldn’t otherwise afford makes the hairs on the back of my neck stand up. I am quite literally afraid of debt.

    I’m applying to PhD programs soon, and any program that doesn’t offer funding options that would allow me to get out of there without taking on debt will be stricken from the list immediately, even if it’s my top-choice school.

    I have no idea how I will deal with this when it comes time to buy a home. Probably, I will learn to live with the idea of a mortgage payment, but I wouldn’t be at all surprised if I turned into one of those “pay it off in a third of the time!” people.

  12. Great post. There are as many different personal finance philosophies out there as people, but you did a good job summarizing the major ones.

    I certainly fall into the “high interest debt is bad” category. My wife has a student loan at some ridiculous rate of 2% or something. We pay the bare minimum on that and put the rest into a savings account.

    With a 5% savings account and a 4% student interest loan, it’s probably a wash (since you have to pay taxes on the savings account interest). It’s whatever makes you more comfortable. Some days I look at the car payment at 4.5% and say “I have enough cash to pay that off.” Other days I say “I need to have that cash in case something else happens.”

  13. Don’t pay off student loan, if you die they go away. So pay off CC, car debt, mortgage, etc. Because those don’t go away especially when joint. Also at 4% potentially it’s tax deductible.

  14. I’m curious how you’re “very vulnerable if you [get rid of debt] too vigorously.”

    Trent, you’re smart and appear to have recently turned your financial life around. You write a good blog. Great job. But this is an area where you show your inexperience.

    Saving in a taxable 5% MM (the return is NOT FIXED) is terrible advice verses paying off a 4% student loan. I’ve done both. I know. And don’t even start comparing investing in the S&P 500, the risk is incomparable (you lost 4% this _week_ right?).

    Seriously, would you borrow $40,000 at 4% to invest it at 5%? That’s what you’re advising.

    The feeling you get from writing that final student loan payment is immensely freeing. Talk about the opposite of vulnerable! You can never ever discount the **PERSONAL** in personal finance. It’s about more than math. At least you kind of seem to recognize that.

    If I were this fictitious person, after first funding a mini-emergency fund (a couple thousand) and then saving to get my 401k matching, I’d be attacking that loan with everything left in my budget. And I can recommend that as someone who’s done it. It works.

  15. Its not fixed forever. They adjust the rate based on the Fed. Just a mere two to three years ago every MM paid ~1.5%.

  16. True, the rates on high-yield savings accounts aren’t fixed, but if they dropped to where my student loan rates were higher, I could move money from the savings account to pay down (or pay off the student loan). My student loans are fixed at 2.75% and I can’t deduct the (negligible) interest, so it’ll be something approaching a cold day in hell when I save money by pre-paying my student loans.

  17. Trent,

    Loved your post – and I think you’re right on the money.

    With an income under $100K, some student loan interest is tax-deductible for the life of the loan.

    Not having an emergency fund means that if the student loan is just paid off, and there’s no money in savings, and the car breaks down or there’s a medical emergency that’s only partially covered by insurance, then most people would have to resort to credit cards. which charge way more than 4% interest.

    It’s a completely personal choice, but as I dig my way out of debt and look toward financial stability, I keep building an emergency fund, because without one, and with my luck, I’d end up right back in ‘bad’ debt.

    One suggestion for the poster – she locked in a good rate, but did she ask if an automatic/electronic payment plan could get her a reduced interest rate? The holder of my student loan gave me .25% off for allowing them to electronically debit my account each month.

  18. I agree that it’s mostly personal choice and what you feel comfortable with.

    Mathematically, I know the best thing for me to do with the money I’ve trimmed from my budget is to increase the amount I invest.

    Emotionally, I can’t bring myself to do it until I have a fully funded emergency fund. But back to the math, I can’t bring myself to put money in the bank at 5% until I pay off my car at 6.9%. So I keep a thousand dollars in my emergency fund, invest the small amount that I’ve put away every month since I graduated from college, and aggressively pay down my car loan.

    But by the time I buy my next car, I plan on having enough money to pay for it in cash. But I’m going to look into financing to see if I can get a loan at a lower interest rate than the savings account that the money is in.

  19. I agree with Eric all debt is not bad. It’s just too much debt is bad.

    I also did a post of Dave Ramsey and his “all cash” philosophy. Some things you cannot always pay cash for such as, law or medical school. Grants and schlorships do not always cover those expenses.
    I like Dave Ramsey for as his view on other debt. But he over do it sometimes. House and student loans should be an exception

  20. @ Robert
    “One of the worst things about student loan debt is they are an unsecured loan.”

    How is student debt being unsecured “one of the worst things”? Since it is unsecured, that means your creditors can’t come and claim any specific property to repay the loan as in the case of a mortgage (secured by your home) or a car loan (secured by your car).

    Now one bad thing about student loans is that even though they are unsecured, you cannot get rid of them through bankruptcy. That is why the rates are lower, because the lender is going to get paid one way (by you) or another(by the government), no defaulting allowed.

  21. Trent,
    I have a agree with Ted on this one. You did not given enough consideration before you gave your advice and it may cost her money over the long wrong. Not only, as Ted pointed out, are the current 5% APY rates not fixed on any savings accounts, but you also did not account for taxes on the earnings. They lower the effective return on savings depending on which tax bracket your reader is in. At best, she may break even or make a fraction of a percent over what she pays in interest….at worst, she will bleed money slowly and the debt will cost he more than she makes in the savings account.

    Now don’t get me wrong, I do not advocate paying down that student loan. I would absolutely take any extra principal and save it. 4% is some of the cheapest money she is every going to see in her life and she should utilize it as long as possible. Your advice was not bad, but I would suggest that she use the “extra principal” to build up a small emergency fund and then start investing the money in a taxable account or a Roth IRA. Either way, if the proverbial **** hits the fan in her life, she can access the money (at least the principal amount in the case of the Roth IRA).

    Is there a risk that she could lose some principal? Yes, absolutely, but the odds say that over the long term she will probably earn way more than 4% or even 5%. Personally speaking, it would be worth the risk to me.

    If, for some reason, she is extremely risk-averse I would probably suggest that she build up a modest emergency fund and then go ahead and start paying down the loan. No sense in spinning her wheels or potentially losing money (if interest rates on savings accounts tank again).

    My 0.02

  22. 4% student loan vs. a 5% savings account. Seems obvious to me. Put your money where the interest rate is highest.

    I realize the savings account income is taxed but the student loan interest is tax deductible so the two balance each other out and my money is still worth more in the savings account.

    So what if the interest rate on the savings account might change in the future. If it does, I’ll move money from the account to the loan THEN, not now.

    Gal

  23. A couple of points behind Dave Ramsey’s philosophy. First I don’t have it in front of me but he is a strong advocate of an emergency fund.

    Second he is clear about the fact that the math might be better to save/invest instead of paying off a 0%-5% loan. However, a lot of people get into problems with 0% cards, or don’t pay down their student loans enough and stretch other areas of the budget.

    If you have the discipline to put the money in savings account and pocket savings interest minus loan interest, then I agree. But, Dave Ramsey deals with a lot people who have screwed up, so he advocates paying debt first.

    Oh and this blog is really great. I’m working on including some personal finance in my Intro to Economics classes, and it has given me a lot of good ideas. Keep up the good work.

  24. Debt is neither good nor bad. It’s economics. Do you want the interest to work for you or against you?

    At the very least, your reader should ask herself what I asked myself two years ago: Do I really want to still be paying for my diploma in 2023? Or do I want to be able to flex my full savings prowess in 2007?

    I had a student loan for $13,000 with an interest rate of 4.9%, and the minimum payment was $90. Paying the minimum would draw it out for 18 years with over $6500 disappearing into the black hole of interest.

    I chose to pay it off aggressively (about $1200 a month) and now that it’s paid off I’m much more healthy, both mentally and financially– I’m continuing to put that $1200 into savings.

    Think about it. Say I only had $500/mo to put towards the student loan. I’d have it paid off in 28 months and would only be throwing roughly $800 away.

    By your advice of paying the minimum, if you invested that additional $410 every month for 18 years at 5%, even with compounding, would generate $54,500 in interest. Subtract 25% for taxes and the $6,500 you p*ssed away to interest on your student loan, and you end up with roughly $34,400.

    As an experiment, follow my path: pay $500 a month for 28 months, and then start investing that $500/mo for the remaining 15-8/12 years. You’d end up with $48,000 and after taxes and student loan interest ($800), you’re set up with 35,200. Hey, you just made $600 bucks!

    Now, would pay $600 for the privilege of paying $90 for 216 consecutive months? I know I wouldn’t.

    (To answer the question of deducting student loan debt, you can only do so if you make a pittance. I’ve never been able to write-off a single cent of student loan debt because I have a decent job making decent money. Of course, “decent money” does not equal “enough money to buy a freakin’ house in Seattle”, but that’s another story for another time but hey, at least I have more money to invest in the meantime!)

    (To answer the fear of not having an emergency fund, I’ll let you in on how I was able to spend $1200 a month to pay down my debt. I did actually just pay the minimum, and I put the $1200 into my company’s ESPP with a guaranteed 15% return (it’s actually about 70% because of a healthy stock price. When it vested, I cashed out and attacked the loan. Contributions to ESPP are fairly liquid– you can pull them out at any time without penalty. So while I was building up a balance in my ESPP I was also maintaining an emergency fund of sorts, all the while generating more income for myself. YMMV)

  25. When it’s all said and done, Trent, I like your advice to listen to your heart. I’ve been spending a bit of time trying to set new financial goals & have been struggling with trying to balance my emergency fund (about 3 months of take home pay) vs. paying down a car loan at 4.6% and a student loan that’s locked at 4.0% (which I’m actually paying more than the minimum payment on, because I realize that locking that low was their way of trying to get you to stretch out the payments for more years & ultimately paying more money overall).

    Right now, on paper at least, isn’t the best option to pay the usual payments and keep my emergency fund (HSBC acct. at 5.05%?)? My income is beyond the cap for much of the interest on the student loan to be tax-deductible, so I guess the more frugal thing for my debt to just stay the course. (Right? Or am I doing the math wrong?) But it’s hard because part of me really just wants to pay off the car debt (which would cut my emergency fund by slightly more than half) and then take Trent’s advice to save what I would’ve spent in car payments every month. I just want to be rid of that debt, I guess.

    Thoughts?

  26. I’m in a situation like Hannah’s: I have student loan debt (~3%) and a car loan (~4%). My cash-on-hand situation is really only about 2 months’ take-home (but it’s enough to cover 3 months’ living expenses).

    I’m debt-averse but I’m also a bit conservative in that I don’t want to cash out my emergency fund just to get rid of the car debt.

    So, I’m going the snowball route: I just paid off my credit card and now I’m doubling up my car payments so it’ll be paid off in May 2008. Then I’ll roll the car money into paying off the school loans by 2012 instead of 2024.

    All along I’ll be saving for retirement and putting several hundred dollars/month away – first I’ll boost my emergency fund, then start house and travel savings accounts.

    So even though it’s not fun or immediately rewarding, I’m doing a combination of aggressive payments tempered with staying the course. It’s nice to know I could pay off my car today, but I don’t think it’s the best use of my money, and more importantly, I don’t think it’s the best choice for me.

  27. I’m with Dave on this one. But I’m no financial guy. I am a people guy and i do know that people have a tendency to get themselves into a mess trying to make the numbers work so perfectly, only to make an emotional or emergency decision later that ruins the 1% differance or so. Not sure if any of that makes sense. Suffice it to say dave’s philosophy is that money management is 20% numbers and 80% mental. If your awesome with money management and discipline then you are right. I have a friend who is exactly that and is in this exact situation and follows your method and it works for him. I think he is the minority though, more the exception than the rule.

  28. Funnily enough I have security issues with money. I like to have a huge great pile of cash sitting around in a savings account more than I like to have my student loan paid off. In an emergency I can’t get at the student loan money. This approach makes me feel better, regardless of whether it is better financially.

  29. Trent,
    I am curious — I agree with what you say about not prepaying your low interest mortgage, and am glad to see you say the same for student loans. However, I’m curious – why do you advocate to pay cash for a car loan, when you can get a loan under 7% pretty easily?

    (can you email an answer, or do you only answer via posts?)

  30. I hate it when people politicize elementary matters such as finance. In finance (especially personal finance), there are NO philosophies worth their time. Finance only has NUMBERS and nothing more. Numbers are numbers are numbers. Math is math, 3 is greater than 2, end of story.

    The 4% debt vs. 5% interest is evidently a good example. If putting the money in the bank will yield roughly a positive +1% each year, it’s financially stupid to pay off the debt, and your friend asking for advice should have known that, instead of following philosophies and ideologies. Next time, let him know that finance is not politics — it’s math.

    What happened to good old-fashioned FV / PV calculation and benchmarking? Well, I don’t know, but I surely want them back.

  31. I use 7% as a number because you can easily get a savings account that earns 5%, plus a lot of those 7% loans are student loans with tax-deductible interest, bringing the effective interest payment down to about 5%.

    Rudd: if you think it’s that simple, you’re missing out. In the modern world, people can’t rely on a stable income, particularly in some employments. Thus, risk due to unstable income is a factor, and an emergency fund is more important than ever. That’s just one example – there are many more that make the situation incredibly complex and impossible to have a “one size fits all” formula, thus a philosophy is needed.

  32. Hi,

    I have a similar question, and reading through all of the posts have been so helpful for me, that I thought I would ask for your advice for myself.

    I’ll try to keep this brief.

    The monkey on my back: A $101K federal student loan at 9% interest

    My dilemma: What can I do to alleviate the almost $800 month in payments for the rest of my life? Refi, etc?

    What also complicated things is my financial scenario:
    -Own an apartment in NYC worth about $275K
    - Current mortgage balance is $96K (at 4.75% fixed)to which I pay extra $50/monthly principal payments
    -Have about $26K in savings (just started my own biz, so need it as liquid emergency account)
    - Have about $1000K in slush fund
    - Have no credit card debt (after wracking up so much debt from school, am deathly afraid of it)

    As another posted said, my feeling is that the student loan debt will be forgiven upon death, and because I’d be paying so much each month for life (it seems), I’m not in too much of a rush to take cash from anywhere else to pay it off. “It’ll be with me forever” is my take on it.

    But is there anything I might be able to do about the debt? I have another smaller loan at about 4%, but was told that to consolidate, the “weight” of the 9% loan would cancel out any benefits.

    Is there ANYTHING else I can do?

  33. My concern is that someone with a $40K degree can’t figure out that personal finance, as in life, isn’t always black and white but is always subject to the whims of fate and personal circumstances.

    Being is debt (as opposed to debt as an abstract value) is a terrible feeling. However, to work on one’s personal finance, feelings have to be set aside momentarily while options are considered.

    Student loans debt has a couple of advantages over regular loans including (1) you can ask that payment be tied to your income paying less when your income is less,(2) automatically deducted from your account (which usually drops the interest rate by 1/4 percent), (3) tax-deductible interest, (4) some companies will reimburse student loans at various rates, (5) student loans can be forgiven by working in certain fields or locations.

    A student loan should be the last place you put your money when working on a financial plan.

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