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.

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