Pay off Student-Loans or invest?
Question: Currently I am a junior in college and will graduate May of 2000. I will come out owing about $22,000 in student loans. The interest on about half of it is 4% (federal perkins loan), the other half is about 7%. I was wondering if I should drag the federal perkins loan out as long as possible since the market averages 9-12%/yr…meaning should I pay the minimum on that and use the money I would have paid and invest. Mathematically that sounds like the logical thing to do…borrow at 4% and lend at 9-12%. I know that there might be some down years ahead, but over a 10-15 year period i’m pretty sure I can get at least 4% in the market. Is there anything I’m missing, is this the logical thing to do? Any input would be appreciated, especially if you had student-loans to deal with. Thanks.
Answer: Well, buying stock isn’t lending. Buying bonds is lending. The way to evaluate the pay-off or invest decision is like this. Paying down the loan is like getting a guaranteed after-tax return of the amount of the loan That is, paying down the loan is like investing at 4%. If you get to deduct some of the interest, you’re net return is somewhat less.
Currently, you can invest that money in Vanguard Intermediate Term US Treasury and get a pre-tax yield of about 5.8%. You’re after-tax in the 28% bracket would be 4.2%. So yes, borrowing at 4% and lending at 4.2% is a better option, even for such a slim spread. If you want to take on more risk by investing in the market, you can expect around 8-9% after tax in most years. A 5% risk premium justifies taking on a much larger amount of risk.
As far as the 7% loan is concerned, that’s more of a gray area. Turning down a guaranteed 7% return to try to get 8% in the stock market is a bit of a dicey proposition. If 1000 people tried it over 1000 time periods, most of them would come out ahead. But about 40% or so would come out behind. And some of them would end up in deep finnacial trouble and not be able to handle the debt.
So I see no reason to hurry paying down the 4% loan. I’d split some of the extra cash between the 7% loan and stock investments until the 7% loan was paid off, then pay the minimum on the 4% loans until they were paid off. Currently I am a junior in college and will graduate May of 2000. I will come out owing about $22,000 in student loans. The interest on about half of it is 4% (federal perkins loan), the other half is about 7%. I was wondering if I should drag the federal perkins loan out as long as possible since the market averages 9-12%/yr…meaning should I pay the minimum on that and use the money I would have paid and invest. Mathematically that sounds like the logical thing to do…borrow at 4% and lend at 9-12%. I know that there might be some down years ahead, but over a 10-15 year period i’m pretty sure I can get at least 4% in the market. Is there anything I’m missing, is this the logical thing to do? Any input would be appreciated, especially if you had student-loans to deal with. Thanks.
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