Most people are better off treating student debt like the plague — avoid it at all costs. But for some professionals such as doctors, lawyers, pharmacists, veterinarians and nurses, taking on student debt might make sense. It’s impossible to enter many of these lucrative professions without specialized training and that training doesn’t come cheap.
If you fall into one of these categories, or you are already encumbered with student debt, all is not lost. Here is a smart strategy on how to deal with that debt without torpedoing your financial goals.
Look at paying your debt as an investment
When you first took on the debt, you made an investment in yourself. Makes sense.
I suggest that you now look at paying off the debt as an investment as well. Consider this. If your student loans cost you 7 percent, you earn 7 percent on every dollar you use to pay down the debt. In fact, it’s like earning 7 percent guaranteed with no risk. Pretty attractive.
That being the case, when you are trying to decide how to use discretionary income, consider all the alternatives and put your money where the highest potential return is. In many cases, the highest return possible is debt reduction.
I know that after you complete school and start working, you might be very anxious to start banking that extra cash and build up an investment account. I get it. But if the riskless 7 percent return offered by paying down debt is your best alternative, that’s where the money should go.
What about building your business or practice?
From a financial standpoint, it could make sense to make minimum debt payments and pour all you can into your business, but it depends on your profit levels. For example, let’s say you have an extra $10,000 and you are debating whether to invest in the business or pay down some of your student loans.
In order to know which way is best, we have to make some educated guesses about future profitability. Let’s assume in this case that if you invest in your business, you will earn an extra $5,000 a year for many years to come.
That’s a great deal because it’s a 50 percent return and clearly a much better investment that simply paying off student loans. If on the other hand the $10,000 will earn less than the 7 percent you have to pay on your loans, the loans are a better place to put your cash.
What about buying a home?
Use the same model to determine if buying real estate is better than paying off your debts. This is a tricky calculation because you have to consider the appreciation of the real estate and maintenance costs in order to approximate the return you’ll make on buying the property. Unfortunately, it’s impossible to nail these costs down with certainty.
On the other side, if you give up renting and buy a home, it will likely cost you more on a monthly basis when you consider all your costs. That could lead to a great deal of stress which is intangible and hard to quantify yet a big price to pay. For many people, student loans are as large as a mortgage. And the last thing you need is to have the equivalent of two mortgages on your back when you are first starting out.
Should you invest for retirement while paying down debt?
Again, the answer to this question depends on the cost of your debt, the potential return on the alternative investment and the risk. Remember, when you pay down debt it’s a guaranteed return. If your student loan costs are high, it may be hard to find a competing better investment.
What about refinancing the student loan?
Refinancing student loans can be a brilliant move if you can reduce the rate. But some people refinance their student debt in order to reduce the monthly payment. This might be OK if your current situation doesn’t throw off enough cash flow. But if your goal is to reduce the payment (without reducing the rate) just so you can invest in a home or for retirement, it could be a big error. If you restructure the loan to have lower payments without reducing the rate all you are effectively doing is increasing the term of the loan — potentially for a very long time.
Student debt should be avoided if possible. But if you already carry student loans, you best course of action is often to work extra hard and pay off those loans PDQ. In some cases, where the return on the alternative is higher than the rate being charged on the loan, it might be fine to reduce the loan payments in order to build up your business, buy a home or start your retirement fund.
The only real way to know for sure is by clarifying the rate you pay on the student loans, estimate the potential net returns from other investments and then choose the highest paying alternative.
Neal Frankle is a Certified Financial Planner in Los Angeles and author of the Wealth Pilgrim blog.