In personal finance circles there is an age old debate whether paying down non-consumer debt such as your mortgage is preferable to investing for your retirement. For students, the principles of this debate extend to the student debt they take away from their post-secondary education.
The common conclusion amongst most experts when they answer this question is that, “You should do whatever makes you sleep best at night,” in terms of managing your debt. I have a hard time with this non-committal answer. I know that it makes some degree of practical sense, but for me, what allows me to sleep easiest is making and saving the most money!
Will Investing Make More Sense Than To Pay Off The Student Loan?
What the argument boils down to is if you think your investments will make more money than the interest you are paying on your loans. This is why anyone who knows anything about money will tell you that the first step to getting on solid financial footing is to do away with consumer debt. Car loans and especially credit cards usually charge rates of interest that are a lot higher than other loans. Even on a 7-8% loan it is tough to say that your investments will absolutely beat this. When you repay debt that interest is considered automatic return! If you could guarantee people 8% investment returns automatically, the vast majority of investors would take that.
Pay Off the Student Loan After The Credit Card Debt
After taking the initial step of getting rid of all this credit card (certain store-specific cards even have rates as high as 29.99%) and other consumer debt the next steps become more debateable. In the article I wrote last week comparing someone graduating with debt to someone graduating debt-free, we looked at how student loan interest rates work. Canada Student Loans are given at the prime interest + 2.5% if you take a floating credit rate, but at prime + 5% if it is a set rate. Provincial student loans vary from province to province. Ontario student loans (OSAP) are the most common and they charge prime + 1%.
The prime interest rates these days are at historical lows, but on average 4-4.5% is probably a safe bet. This means that you will be paying about 7% on your Federal loans, and 5.5% on your Provincial. At these rates I can see how some might want to pay these loans off, but it is important to realize that the interest you pay on student loans is tax deductible. This means that the effective rate would be about 1% lower than those above.
So if the effective tax rates for Federal student loans is around 6% (over the life over your loan) and the Provincial loan around 4.5% then it doesn’t take a genius to figure out that anything above the minimum payments should go towards paying off the higher interest rate first. The real question is, if you have $500 left at the end of the month should you pay down your student loans at those interest rates or invest the money? Again, some people claim that they can’t sleep because of debt so they pay off the debt first. Personally, my only consideration is what will give me the most money in the long run.
If you are investing money for the long run you can afford to put the money in equities that carry more risk than bonds or GICs. If you don’t need the money for many years and subsequently are not vulnerable to a short-term market down turn, you will get much higher results by investing the money in equities of some kind. I won’t get into investing detail in this post, but I will say the stock market as a whole has returned over 10% per year since its inception. Almost all financial analysts would be comfortable planning on an 8% interest rate as a minimum for basic index-fund type of investments over the long term. One could also likely assume that they would invest the money in registered accounts (such TFSAs and RRSPs) which would allow the money to compound tax free.
Pay Off the Student Loan or Invest?
So, should you invest your money and earn 8%, or pay off the student loan which costs you 4.5% and 6% after taxes are taken into consideration? You might be able to make an argument for the guaranteed 6% return of paying off the Federal debt first, but personally I am going to pay off the minimums, take the tax deduction and start pouring money into equities in preparation for an early retirement! In today’s low interest rate environment, the cost of the loans is even cheaper than the averages we looked at above so it slants the arguments even more. If you have the ‘stomach’ to handle investing the money (secure in your knowledge of the past economical cycles) then I think you are almost assured to come out ahead in the long run.