A Nation Shackled by Student Loans: How to Pay Down Student Loans

Student loan debt has become a ball and chain for many recent grads. Student loans have been a blessing and curse in my own life. On one hand, this loan provided the financial means to earn an education, but on the other, the monthly loan repayments will keep me in debt for years to come.

More Millennials have lived in their parents’ basements than the preceding generation. Low numbers in the job market, as well as, recent graduates struggling to find jobs are big and real concerns. For those lucky enough to have a job, the ability to move back home helps pay off their student loans faster, but what of those who want to reach financial independence while still striking out on their own?

I graduated with nearly 45k of debt to my name. The upside was that I did receive a degree that increased my earning potential. Even more useful was that the mountain of debt helped fuel my interest in personal finance. I was motivated as I dove into books. I discovered the best ways to optimize my net worth while paying off my student loans.

The stories below represent multiple alternatives on how we can approach paying back our student loans.

Three Approaches 
Let’s discuss the merits of how three 25-year-olds could approach their debt in 2016. Apprehensive Andy, Middle Madison, and Investor Ian all have $50,000 in student loans with 10% interest (all interest is calculated at the end of the year)*. For simplicity, all three desire the same lifestyle, costing an average of $25,000/year. Each expects an income of $74,000 and $10,000 in loan obligations in 2016. Where these three differ, however, is that Andy wants to pay off his debt ASAP, while Ian wants to minimize his taxable income, and Madison is content with doing a mix of both. Let’s walk through how each handles 2016.

Apprehensive Andy:

74,000 realized income
-24,000 taxes (32%, about 1/3rd)
50,000 after-tax income
-25,000 payment towards debt
25,000 left to pay for rent, food, commute, healthcare, etc.

Andy has eliminated half of his debt. In addition to making the minimum payments, he’s saved himself an additional $1,500 in interest on all those extra payments ($15,000 x 10% interest).

We can calculate Andy’s 2015 net worth as follows:

Assets: $0

Liabilities: $27,500
Net Worth: -$27,500

Middle Madison: 

74,000 unrealized income
-10,500 (401(k) to match & 5,500 of Traditional IRA)
63,500 realized income
-20,500 taxes (~32%)
43,000 after-tax income
-18,000 payment towards debt
25,000 left to pay for rent, food, commute, healthcare, etc.

Madison decided to set up an IRA and contribute to her 401(k) to benefit from her employer’s match of $3,000. Her additional student loan payments saved her $800 in interest ($8,000 x 10% interest).

Madison’s 2015 net worth comes to:

Assets: $13,500
Liabilities: $35,200
Net Worth: -$21,700

Investor Ian:

74,000 unrealized income
-23,500 (maxing out 18,000 of company 401(k) & 6,000 of Traditional IRA)
50,500 realized income
-15,500 taxes (30%, little less to reflect tax brackets)
35,000 after-tax income
-10,000 payment towards debt
25,000 left to pay for rent, food, commute, healthcare, etc.

Investor Ian will be hit with a much larger appreciation of his debt at the end of the year, rising from $40,000 to $44,000 with the 10% interest rate. His company’s 401(k) match helps ease the pain and more importantly, his minimizing taxable income approach ends up paying off.

Investor Ian’s 2015 net worth:

Assets: $26,500
Liabilities: -$44,000
Net Worth: -$17,500

Final Tally: Embrace the Chain
Not only does Ian come out way ahead of Andy with an additional $10,000 added to his net worth, he also builds an asset buffer in case he loses his job and needs to liquidate his accounts (albeit, at a penalty).

Ian’s uncommon approach to student loans left him wealthier thanks in part to the US Tax Code.

Middle Madison falls in between,trailing Ian by $4,200. This example does not factor in long-term capital appreciation (the true beauty of this scenario) or dividends (currently 2.00% yield on the vanguard total stock market index). The compound interest on Ian’s $10,000 net gain in comparison with Andy will place him ahead by nearly $290,000 in 40 years when both men reach the age of 65. (Assuming a 7% annual return coupled with an average 2% dividend yield reinvested)

If we feel that Apprehensive Andy will catch up to Investor Ian once he pays off all his debt, we would be wrong. These two will only grow further apart as time goes by and as Investor Ian continues to take full advantage of the tax code to lay the foundation for his future financial independence. Perhaps Middle Madison is the route we are more familiar with, but she too will continue to trail in the following years.

Furthermore, how will Apprehensive Andy handle his mortgage in the future? How will Investor Ian?

Master Distiller

*Disclaimer: this discussion ignores the topics of: 1). debt being a curb against inflation which is another benefit to holding onto debt longer, 2). the reduced financing costs of debt over time given rising income and 3). the realization of the long term tax benefits from government allowed deductions on interest payments for student loans.

4 comments… add one
  • Gail @The_KnittyKitty Sep 1, 2016, 8:19 am

    Hi Matt! Very thought provoking read. I’m currently in a similar situation (40k in school debt, but unfortunately my salary is no where near that high). I guess I’m a middle Madison because I’ve been investing and paying off as much debt as possible while keeping my living costs very low. Any more advice for a middle Madison??

    • Distilled Dollar Sep 1, 2016, 8:49 am

      That sounds great – that you’re keeping costs low. That will be the largest driver at the end of the day.

      I wouldn’t offer any advice without knowing more details – but from the sounds of it – I would say you can play out the different scenarios and see what the $$ difference is at the end of the year. For me, the $ amount was large enough for me to opt for the investor route.

      I hope that helps! Feel free to follow up if you have more specific questions and you can always email me directly at [email protected]

  • OMGF Dec 11, 2017, 11:02 am

    Some of these numbers are a bit confusing because of contribution and income limits. If Madison is only contributing $5000 to her company 401K that brings her taxable income down to 69,000. Are you including deducting student loan interest in her AGI? At $69000 she would not be able to deduct the full $5500 of IRA contribution because that’s within the phaseout range. Or are the AGI limits inclusive of the IRA deduction too? Hope these questions make sense.
    Regardless of the exact tax numbers the general principle is consistent. Math over mind or mind over math, that is the question. Some people are just super uncomfortable with debt, no matter the math. I also factor cashflow into the equation. It doesn’t matter how much tax savings or annual return you’d get vs. paying the loan if the loan payment itself is so high that it disrupts cashflow. I kept my student loan for much of the reason that you outlined here (tax savings on 401K, higher return, time, etc.). I’m able to do so not only because the interest rate is low, but also because my total balance is low enough where the monthly payment takes less about 6% of monthly disposable income. I pay significantly more than the minimum and still have plenty for investment and living. Point being, I think that is another part of the equation that’s important to consider.

    • Distilled Dollar Dec 11, 2017, 9:50 pm

      I can write a few posts on this topic and I’ve sprinkled this throughout the last year – but I’ve made a personal mission of mine to redefine how debt is handled. My personal view is people become comfortable eliminating debt because taking that next step to invest is scary. I 100% relate to what you’re saying, when you say, “some people are just super uncomfortable with debt,” and being uncomfortable is the way things are at times.

      I would add that being uncomfortable with debt and not investing should make someone frighteningly uncomfortable, but the reality I often see is people have a tendancy to block out investing, and put it off for another day. After hearing countless advice on, “invest early,” and, “compound interest is the 8th wonder…,” after hearing all that, I’ve committed to advising everyone should invest no matter what. Even if it is $1 a day because psychologically it does something. It literally turns someone into an investor (which is amazing), but it turns money into a positive in many ways. Plus, most important of all, it begins to build the habit. I’ve seen too many close friends be burned by accelerating student loans only to be left clueless on what to do next when they’re done paying off a mountain of debt.

      I can go on for days as I’m always fired up on this topic. I also agree with what you’re saying, but I would just add investing early, no matter how small, is about building the right habit. Outside of the habit, it tends to create this new puzzle over, “okay, how should i invest?” or, “what if my $10 investment goes to $0?” and other helpful questions that come front and center, often many years earlier. Thanks again for the comment.

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