A major component of the Financial Independence Retire Early (FIRE) lifestyle is a focus on reducing debt to zero, saving 50 percent or more of post-tax earnings, and limiting expenses. 

Discipline over time instills the second two components as an everyday part of life. But for me, the debt component is frequently in my thoughts.  Specifically, what to do about my remaining student loans.

I hesitate to characterize some debt as “good debt” and other debt as “bad debt.” That seems like a fallacy cooked up by the lending industry to convince the consumer that borrowing large sums of money leads to a positive outcome. That is false, there is always a risk of bankruptcy in borrowing. However, in the interest of precision, perhaps we can define some debt as “calculated risk debt” and the other as “terribly awful, in no way good for you debt.”  

I would put my mortgage in the first category. If I lived in my home it would provide  shelter. It would also build equity to enhance net worth at the cost of interest payments. The interest, helpfully, also offers a deduction against my taxable income. Put another way, the mortgage liability allows me to purchase an asset that hopefully grows faster than that liability. Because my house is an income property

If the asset fails to produce, the debt is still the bad part that will lead to bankruptcy.  If it succeeds, it is the asset that created the success.  The liability only enables you to purchase the asset.

The second category includes credit card debt, automotive loans, and personal lines of credit. Really any loan that encourages consumption or purchases beyond the individuals current assets. What about student loans? 

“But, but, but Mr. FIRE Power!” You may the thinking to yourself. “You’ve miscategorized student debt! It  increases lifetime earning, it builds networks, it’s a gateway to the middle class.” Yes, yes, yes, fine fine. 

Student loans fall someplace in the middle.

I have a student debt conundrum on my hands. During graduate school I took out $21,166 in student loan with a 6.55 percent interest rate. 

Just to make sure we’re all on the same page, let’s look at the difference between subsidized and unsubsidized loans.

• Subsidized: The department of education pays interest on the loan while the students is enrolled in school and the six-month grace period after leaving school. The interest is also covered during periods of deferment. 
• Unsubsidized: The interest payments are the responsibility of the student immediately upon receiving the loan. It is possible not to pay the interest during school or deferment. However, interest will accrue (accumulate) and be capitalized (that is, your interest will be added to the principal amount of your loan). Ouch.

Its been nine year since I left graduate school. How much do I owe today? 

$5,385.55. So that means I have paid $15,780.45 of principal, or more than 75 percent of the original loan amount. Not too bad. But this leaves out the interest I’ve paid over the years, or a total of $5,849.60. So while I was paying down three quarters of the debt, I paid an additional quarter of the debt for the convenience of having the loan. 

Today, I have a monthly payment of $178. At that rate, it will take 34 months to fully pay off my student loans. During that time, I will accrue $517 of interest. 

The question I struggle with now is what should I do about my loan principal. I have $5,385.55 in the bank today. I can pay off the complete principal of my student loans tomorrow. But research suggests the better financial decision is to keep the monthly payment low to take advantage of time and compounding interest. 

As I consider this, I wanted to look at stocks and savings for a major (income generating) purchase. 

Invest in the markets

Inspead of accelerating debt payment, that capital can be deployed in the stock market. As we’ve discussed before, the historic average rate of return of the S&P500 over decades is about 7 percent after accounting for inflation. 

The simple rule of thumb is that if the market return exceeds the student loan annual interest rate then investing is the better option. In other words, you make more money in the stock market than you pay in loan interest, so better to invest than the pay off student loans. 

Unfortunately predicting markets is a difficult proposition. If the market declines, then the capital invested could better have been targeted at repayment. 

Paying off a student loan offers a guaranteed return. You know the term of the loan, the monthly payment, and interest rate, so you can calculate interest paid over that period. Those savings are the guaranteed return on investment for paying the full principal or accelerating payments.

Lets take a look at my loan and different scenarios. 

Assuming a 7 percent market return and a long term buy and hold strategy, there is no compelling financial reason to pay off my loan early.  That is generally true as well when the annual return is lower.

These numbers look a lot more dramatic when the numbers are larger, see an example with a $50,000 loan. 

The numbers above paint a clear picture. Investing in markets offering a historical average investment return, or better, offers better returns than accelerating a repayment plan.

Save for a large investment

Perhaps you’ve reached your contribution limit. Or you have a different financial goal. Not everyone is interested in investing available capital in the stock market.

My current goal is real estate investment and purchasing a second investment property. Unlike my first property my next purchase will require at least a 20 percent down payment. I’m aiming to purchase a property between $250,000 to $300,000, so that requires a down payment between $50,000 to $60,000. 

To reach that goal, I park a regular monthly payment in a Goldman no frills savings account. It returns 2.25 percent APR. There is much to be said about Goldman Sachs, but this is among the best savings accounts out there in terms of APR. 

For me, the security of holding the housing saving in a low-risk saving account is worth more than the potential upside of investing in the market. It also lays out a clear monthly savings timeline that leads to a fixed purchase date: December 2019. 

As we know, if I pay the full $5,385.55, I save $590 in interest over the remaining 38 months. 

To do so would have two potential impacts on the second house purchase. First, that timeline above would be put off for a period of time until I could replenish the loan payoff amount. Second, I can maintain the December 2019 purchase date for the new property, but would lose $25,000 in purchase price from the leverage offered by the new mortgage. 

This second scenario also seems to imply that it would be preferable to maintain the current loan payment instead of paying off the principal. 

The psychological benefits

Despite the numbers above, there is still a psychological impact of carrying a big loan balance. Hopefully the data helps to rationalize why it is better to maintain a loan balance–despite how it makes you feel–because it is the better financial decision.

Conclusion

As much as it pains me to say it, in my case, the benefit of slowly repaying student debt outweighs accelerating or paying off debt immediately. Considering my personal goal of purchasing another property, it make sense to continue the monthly payments (and interest) over the immediate gratification of living student debt free.