Over $20,000 Ahead After 3.5 Years of Income Based Student Loan Payments

It has been almost 3 years now since I wrote my first article about my plan to seek student loan forgiveness using an income based payment plan instead of paying down my debt aggressively. About a year after that, I wrote an article about how I made a mistake in which income based repayment plan to choose. A few months after the original post, I changed from the PAYE plan to the REPAYE plan which is a much better option for my situation.

To say that those posts were controversial would be an understatement. I got a ton of messages both here and on Facebook from people who either wholeheartedly agreed with my analysis or vehemently disagreed for a variety of reasons.

The main disagreement had to do with the risk involved in keeping the debt and investing heavily versus paying down the debt quickly. I was concerned about the risk as well but ultimately decided that the upside was worth much more than the potential, relatively small, risk of a big stock market decline. As it turns out, since I started making student loan payments in 2015, the market has been very good, but of course there was no way to know that would be the case back then.

I wrote a later article that offered a more moderate option of simultaneously taking advantage of the tax benefits of investing in retirement accounts combined with paying down student debt which resonated better with many people. But for me personally, I stuck to the “pay the minimum and invest the difference plan” that I originally settled on, despite the risk.

It has now been 3.5 years that I’ve been making income based payments on my loans while investing my extra money into retirement and brokerage accounts. The intent of this article is to compare what my net worth is now from investing versus what it would have been had I aggressively paid off my student loan debt as quickly as possible.

Before I get into the numbers, I want to make my standard disclaimer:

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation.

My Situation

If you’ve read my articles in the past, then you undoubtedly know that I’m a big proponent of using travel therapy to improve your financial position, which can be huge as a new grad (the route I chose). Doing travel therapy early in your career, with the higher earning potential, allows more ability to invest early and take advantage of the benefits of compound interest. With the higher income from travel therapy, I was able to save over $100,000 within 18 months of graduating physical therapy school.

My starting student loan balance was just slightly under $94,000 which I would have been able to eliminate in about 18 months (this is factoring in the higher taxes that I would have had to pay without the benefits of pre-tax retirement account contributions during that time) of focused effort on debt pay down. Had I gone that route, I would have started investing all of my left over income as soon as the student debt was gone. In either scenario, I would have had to use some of my earnings up front in order to pay for our truck and fifth wheel camper, so that’s a constant in the calculations.

My investments have been primarily domestic equities, but I also have put money into international equities, emerging markets, precious metals, energy, and crowd funded real estate (Fundrise) over the years. In reality, most of this has been increased complexity for about the same return as I would have gotten with just a regular domestic equity index fund, but my main reason for spreading my money between so many places was for increased diversity in case of a big drop in one specific sector. No matter when I started investing (either right away like I did or after paying down my student debt in the hypothetical situation) my investments would have been the same, so that is a constant as well in these calculations.

The main difference here to look at is the opportunity cost that I would have incurred by paying down my student debt instead of investing, which is the flip side of the risk of a market drop that I talked about earlier.

Since my investment returns have been significantly better than my student loan interest rate, my net worth would have been lower if I had paid off my loans right away, and the difference in the two interest rates is what I want to examine.

First, let’s look at my average interest rate on my student loans.

I have a total of 8 different student loans, which were all from grad school. The interest rates range from a low of 5.2% to a high of 6.6%. Calculating the weighted average gives me an average interest rate on the total balance of 5.95%. This includes a slightly discounted interest rate that Navient gives me for signing up for auto pay.

• Average interest rate on student loans: 5.95%

At that interest rate for any other debt, I would undoubtedly pay it off as quickly as possible, but the potential for loan forgiveness changes things. The other factor we have to consider is what my actual effective interest rate ends up being once the subsidized accumulated interest is accounted for while on REPAYE. Right now, my income based monthly student loan payment is only $85 due to contributing heavily to retirement accounts to decrease my taxes, which also serves to lower my AGI and subsequently my student loan payment. That $85/month is no where near the interest accumulating each month, which means my balance is steadily growing. I would currently have to pay $512/month just to cover the interest accumulating each month! The average that this interest has accumulated over the past 3.5 years is $501/month. My average income based student loan payment over the past 3.5 years has been $49/month. If I had been on REPAYE that entire time, then I would have been accumulating an average of $452/month in interest, half of which would be subsidized each month. That would leave me with my student loan balance growing at an average of $226/month ($2,712/year). Unfortunately it wasn’t until 9 months after graduation that I discovered REPAYE and switched, so for that first 9 months that entire amount of accumulated interest each month was being added to my loan amount. This is a bummer, but it didn’t make a huge difference in the grand scheme of things. In reality, my loan balance has grown by $10,872 since graduation, for an average yearly increase of $3,106 over the 3.5 year period.

I know this is a lot of math, but stick with me. These calculations are vital to figure out what my actual average effective interest rate has been while on REPAYE in order to determine how much ahead or behind I am by choosing to invest instead of paying down the debt. In reality, with all these factors considered, my student loan debt has been growing at an average rate of 3.65% per year.

The payments that I made each month are factored into this equation as well. As you can see, this is more than half of the weighted average interest rate above due to the first 9 months of me not being on REPAYE and the small monthly payments I have had since graduation. In a scenario where my payment was $0/month (a situation that many travel therapists who contribute to retirement accounts are in), and I had been on REPAYE since the very beginning, this percentage would be exactly half of the 5.95% interest rate above.

• Average interest rate at which student debt is accumulating over the past 3.5 years: 3.65%

Alright, so now that we know the rate at which my student debt is growing, now we need to look at the other side of the coin. What has been my average return on my investments over that same time period?

By looking at that, we can determine what that same $94,000 (that I would have used to pay off this student debt, which is steadily growing at an average of 3.65%/year) has turned into by investing it instead. Over the past 3.5 years, my average yearly return on investment with the portfolio I talked about above has been 8.9% (this is with dividends reinvested). Prior to the big drop in the market in December, this number was actually over 10%!

• Average investment return over the past 3.5 years: 8.9%

Figuring Out How Far Ahead My Net Worth Is

Now we know:

• How quickly my student debt would have been growing if I had paid it down aggressively (5.95%)
• At what rate my student loan debt has actually been growing on average each year (3.65%)
• And what my average investment return has been during that same period (8.9%)

So, now we can figure out the difference between how much money I would have (my net worth) if I had paid off my debt quickly, versus how much money I actually have due to investing that money instead!

These calculations are complex due to calculating compounding returns. I’m not excel savvy enough to do them on my own, so I’m going to use a compound interest calculator to help. Let’s check it out below.

• After the first 18 months:
  • Scenario 1: The debt would be completely paid off (paying $5,500/month) in the ‘paying down the debt aggressively’ scenario, and during that time my total student debt would have grown from $94,000 to about $99,000 that would have been actually paid to the loans (5.95% average interest rate, but growing at less than this due to being paid down over the time frame). Investment accounts would be starting from $0 at the beginning of month 19. This would be a net worth of $0 at this point.
  • Scenario 2: The student debt would have grown from $94,000 to $99,300 (3.65% for 18 months), but the money saved and invested would have grown to $106,300. If we subtract the debt from the amount in the investment account, we can see that net worth in this scenario is $7,000.
• After the full 3.5 years:
  • Scenario 1: Debt is fully paid off as stated above. Now, all of the money that I was putting toward student debt ($5,500/month), I would then be investing at the same average interest rate as my investments in scenario 2 (8.9%). This leaves us with an ending balance in the investment account of $145,000. Total net worth is $145,000 at the end of 3.5 years in this scenario.
  • Scenario 2: The $99,300 in student loan debt continues to grow at 3.65%, and we end up with a ending student loan balance of $106,800. The money in the investment account continues to compound and grow at the average 8.9% interest rate along with continued contributions ($5,500/month). This leaves us with an ending investment account balance of $271,900. To get total net worth in this scenario, we subtract the student loan balance from the investment account balance which equals $165,100 at 3.5 years!

To Summarize:

• Net worth after 3.5 years when aggressively paying student down debt: $145,000
• Net worth after 3.5 years of income based repayment while investing instead of paying down student debt: $165,100

That’s over $20,000 difference in net worth in 3.5 years!

That means that had I decided to pay down my student debt quickly instead of investing the money like I chose to do, I would have over $20,000 less than I do right now.

That’s a massive difference. This isn’t even considering the fact that there’s the potential that the student loan debt will be forgiven after 21 more years of payments, and all I’ll be liable for is taxes on that forgiven amount. If that happens, then this one decision (investing instead of paying down the student debt) could be worth hundreds of thousands of dollars in total over a 25 year period!

Conclusion

There’s no way to know what the future holds as far as things like investment returns and student loan forgiveness. The best we can do is use the past as a guide with some informed opinions on the future.

I returned to my decision to invest instead of paying down my student loan debt dozens of times just to recheck the math and make sure I was making the best choice I could based on the odds. That single decision has been worth over $20,000 in a 3.5 year period, and could potentially be worth well over $100,000 over the next 21 years.

There’s always the possibility that the market crashes and I lose 50% of my investments, and in that case then I would be significantly behind where I would be in I had paid off my debt. But, even if the future returns aren’t nearly as good, it will be very difficult for the $20,000 I’m ahead by to be completely wiped out, so the odds are still in my favor to continue down this path.

As long as I can continue to have a 3.65% interest rate while on REPAYE, with the potential for loan forgiveness in the future, I’ll continue along this path. In fact, even if loan forgiveness wasn’t on the table, I would still gladly keep the 3.65% effective interest rate student debt and continue to invest.

I understand that debt is not always just about numbers though, and for some people not having debt can be priceless. So, I fully realize that the above option that I’ve outlined for myself is not for everyone.

If you have student debt, what did you decide to do about it? Did you pay it down aggressively or invest? Are you happy with how your journey to financial freedom is going due to that decision? Let me know in the comments below!

**** It should be noted that taxes were not considered here due to added complexity, and the fact that this post was already getting very long. The student loan interest deduction would benefit the investing scenario slightly, whereas having to pay taxes on dividends and capital gains would benefit the paying down debt aggressively scenario. In my current marginal tax bracket, I don’t owe any taxes on qualified dividends or any capital gains I harvest. In my case, the tax situation would likely be pretty close to a wash, whereas if I was in a higher marginal tax bracket it would have a bigger effect.