I’m a firm believer that money greatly affects your well-being. Your financial life is your life. Some say money can’t buy you happiness, but by breaking your consumerist spending habits, you’ll see that building wealth will give you freedom from work, more time with your family and friends, and the mental bandwidth to pursue your passion projects and hobbies. To me, this is true luxury.
This is a blog for those of you with more than a passive interest in personal finance. You’re feeling your soul crushed by the weight of your student loans, and maybe even *gasp!* credit card debt and auto loans on top. I’m here to help with authentic informed guidance, to help give you the tools to tackle your personal finances with the same passion, intellect, and hard work you direct towards your professional craft. I will assume that you, reader, are not here because you’re looking for emotional motivation to take control of your finances. You’re not reading this for feel-good strategies. You’re here to simply learn the smartest ways to manage your financial life.
Distracting You From the Best Path
This is probably not your first rodeo with personal finance blogs. It’s a massive industry populated by plenty of smart, interesting writers. The problem is that much of the advice verges towards self-help. It’s much like treatment for addiction. You learn to boost your will power and resist temptation. David Ramsey’s debt snowball strategy says you should pay down your smallest debts first, even if it’s not your most expensive debt. By paying your smallest debt first, you’ll get the happiness boost sooner from paying it off. That, in turn, will snowball into more motivation to pay off your other debts. This works really well for some people.
Here’s the problem. There’s a hidden trade-off. By taking a sub-optimal path (not paying off the most expensive debt first), you’re paying for the motivation. It’s not always clearly disclosed that the strategy explicitly advocates against the optimal financial decision. The idea is that a feel-good motivational strategy is preferable to one that actually does the best job at maximizing your wealth. The assumption is that you’re not capable of carrying out true optimization of your finances because you lack the motivation and drive. To be fair, a feel-good financial method works for many. Without drive, there won’t be progress. These strategies have undeniably helped millions reduce debt and build savings. I’m just here to dig in a little farther.
You don’t need motivation. Instead, I assume you are seeking logical, well-researched guidance. You are an educated professional. You litigate. You operate. You code. I’m writing this blog under the assumption that you will read it as a rational actor, that you lack direction, perhaps, but are eager to find a better way. I’m a persistent economizer, optimizer, and rational strategist, and I think you are too. Welcome!
Pay Off Your Student Loans As Slowly As Possible
Now to the task at hand: seriously, don’t pay them off. I’m talking to you, newly minted attorney/doctor with >$100k in student loan debt. Maybe you’ve been living off your refund checks through school and have >$200k in student loans. You’ve probably already completed the unseemly task of logging into the variety of servicer websites, finally confronting the nebulous sum you knew was accruing behind the scenes as you coffee-shop-latte’d and corner-store-PBR’d your way through the rigorous study/party cycle of your highly esteemed professional training. By now, you have confronted the whopping thousand-plus dollars you’ll soon need to start paying towards your loans each month.
To be clear, I’m not saying default on your loans. Although, fleeing to Ecuador is a noble choice for a choice few, I’m going to assume you wish to remain gainfully employed as a U.S. resident practicing your professional craft for at least a few years (early retirement will be covered in a later post). For you, hard-working American professional, my recommendation is this: pay as little as you can on your student loans. I’ll walk you through how to dial this in in greater detail, but first, a little about myself.
Who Is This Broke Lawyer?
Full disclosure: I graduated from a fancy law school in 2013 with a modest $235,000 in undergraduate and law school loans. My interest rate averaged 7.2%. My monthly payments totaled roughly $1500 using the Extended Graduated Repayment plan, which allows for the smallest minimum payment in the first few years out of school. If you’re into math, you may have already done the rough calculation that my monthly interest payment on 235k at 7.2% was roughly $1400. Of $1500 that I paid every month, $1400 went to paying that month’s interest! After a glorious year of siphoning off $1500/month after tax, I found that I had slayed a mere $1200 total after crapping away $18,000 in post-tax income. To be clear, these payments would be enough to cover the leases on two brand new Teslas. Not a modest sum.
Looking at this dire reality, I’m guessing your first reaction is to come out swinging, to pay as much as absolutely feasible towards your student loans. After all, the lower your balance, the lower your interest payment. This is standard advice, and it’s admirable for its simplicity. But, it ignores two things: 1) opportunity cost and 2) liquidity.
Opportunity Cost: Or How I Learned to Love Interest Rate Arbitrage
You should consider the opportunity cost of paying off your student loans, and what else you could do with that money. Student loans can be carried at moderate interest rates, and should therefore be considered as a contemporary strategy to the mortgage. Buying a house with a mortgage is a leveraged strategy of going long on the U.S. Dollar over a long timeframe. It also provides a hedge against housing cost inflation. You’re locking in your “rent” payments for the next 15-30 years.
Imagine receiving an offer for unlimited debt at zero percent interest. Say yes! This is an opportunity for near infinite leverage. Accordingly, low interest rate, long maturity (15-30 years, typically) debt should be considered in certain circumstances. Your return on the debt used to invest would be the difference between the interest rate paid on the debt and the interest rate returned on the borrowed funds. Thus, the option to borrow large sums of money at zero percent interest is pretty much guaranteed to make you very, very rich.
Clever Use of Leverage
If you can borrow $100,000 at 4% interest and return 10% annually on that amount from an investment, you would have returned a gross profit of $6,000 (ignoring pesky taxes). You paid 4% in interest, $4,000, and received 10% in revenue, $10,000. Say that borrowed $100,000 was coupled with $100,000 of your own funds. You’re 50% leveraged. You gain 10% on the cash investment plus 6% (10%-4%) on the borrowed funds. Thus, your overall return on your cash is more like 16% because you’re getting a boost from the gains on the borrowed dollars.
You should always be in the market of considering how expensive your debt is. Many times, cheap debt should not be paid off immediately, but instead should be leveraged into other investments.
There are many reasons to take on leverage, but also many good reasons to avoid it. Generally, too much leverage introduces fragility. If you’re leveraging all your cheap debt into very risky investments, you risk catastrophic loss. Catastrophic loss is bad.
Diverting Your Student Loan Repayment Funds to More Profitable Investments First
I will explore much of this in greater detail in later posts, but the takeaway is this: paying down your student loans has a fixed return of the interest rate on the loan. What’s great about paying down debt is that this return is risk-free and known in advance. When you invest in, say, stocks, the return is not known in advance, and is subject to large fluctuations. However, with a sufficiently low student loan interest rate (I refinanced my student loans and cut my interest rate in half with Earnest – check it out here), you may be able to invest that money elsewhere and achieve higher returns.
A very easy example is “investing” in paying off your credit card debt. If you’re paying 25% interest on your balance, you should obviously pay that off prior to paying towards your lower-interest-rate student loans. Similarly, you may be able to invest that money (down payment on a house, buying a rental property, funding your business) at a greater rate of return. Under this strategy, you can actually accelerate the process of paying off your student loans by diverting the money to higher return investments first and deferring accelerated repayment of your student loans.
Liquidity: The Clever Person’s Emergency Fund
Common wisdom is that you should keep 3-6 months of spending reserves in cash. That way, you’re prepared in the event of a loss of income, etc. You obviously shouldn’t be living paycheck to paycheck, particularly if you’re making payments on debt to finance discretionary purchases (I’m looking at you, Mr. 2016 Ford F-150-purchased-on-credit). Cash is awesome because it’s liquid. In other words, it’s always there and you can draw from it on a moment’s notice. The trade-off is that you don’t earn any money on cash.
Compare putting your savings into cash to putting your savings into paying down your student loans. Paying down debt is a highly illiquid investment. What does this mean? It’s a one-way ratchet! Once you send off that $5,000 check to pay off a chunk of your student loans, you cannot re-borrow that money as you see fit. That money is gone, it’s stuck in the investment. You reduced how much you owed and are getting a return in the form of not having to pay interest anymore on that $5,000. That’s a solid investment. But, it is not capable of reversal. You cannot pull that money back out if you need it.
Here’s a simple example: Karen has $50,000 in student loan debt at 5% interest. She gets a bonus at the end of the year and decides to throw all $10,000 of it at her student loans. In fact, Karen is a savvy saver and has been investing all her excess funds into paying off her student loan debt. Accordingly, when a few months later she gets hit with a massive unexpected bill of $10,000, she’s forced to use credit cards and ends up carrying a balance at 15% interest. Whatever gains she got from saving 5% in interest were quickly erased by the 15% interest she’s now paying on the credit card balance!
Because “investing” in paying off your student loans is highly illiquid, it should be balanced with other more liquid investments such as stocks, bonds, and even real estate. Aggressively paying off your student loans right out of school is extremely risky without other liquid savings and an emergency fund.
How do you balance between saving an emergency fund in cash and diverting your savings towards paying off debt? Well, I advocate a middle ground approach: divert a comfortable amount (multiple months of spending) into suitably liquid investments like stocks and bonds (I will discuss the best ways to invest in a later post). You’ll earn a long-term return on the investment versus the negative returning of sitting on cash (remember: cash loses value over time due to inflation). Should you hit a rough patch, you can draw down from these investments without resorting to expensive credit card debt. This is a bit of a simplification, but it will suffice for now.
The takeaway is: evaluate investments based on risk, return, and liquidity. It will be well worth it to preserve liquidity (particularly when you’re a financial infant with very little savings) by investing into index funds, than to channel all your savings into student loan debt. Again, you cannot re-borrow on your student loans. If you find yourself needing some of that money, it is far better to pull it from index funds or other liquid investments than to re-borrow on worse terms in the form of credit card debt, etc.
What’d You Think?
This is my first post, so please let me know how I’m doing. Are there things you want more or less detail on? Any questions? Looking forward to hearing from you, and more posts coming soon.