Student Loans vs Debt Free – A Lifetime Comparison

For many people student loans are a fact of life. They always knew they would have to get them, and when they did it wasn’t a big deal. After graduation the loans were always there as they started their working life, so they probably never considered what the true cost of the loans was. In order to motivate people to save for their post-secondary education I thought it might help to examine how much it really costs to start off your working life climbing out of debt instead of building your wealth.

When trying to calculate the real impact of what a student loan will cost you, we first need to look at the breakdown of where a student loan comes from. For most students 60% of their loan comes from Canada Student Loans and the other 40% comes from Provincial Student Loans. This is important because of the effective interest rates. For your national loans the government offers the choice of a fixed loan at 5% above prime (probably not a good option) or a ‘floating’ loan (this means it increases or decreases as the Bank of Canada’s lending rate goes up or down) at 2.5% above prime. Provincial loans are all unique. The most commonly discussed loan is from Ontario (OSAP) and it is for 1% above prime, while Manitoba’s by comparison was 2.5% above prime until 2009 where they decreased it to 1.5%.

For simplicity in our calculations were going to assume an average prime interest rate of 4.5%. In today’s economic climate this would be considered a pretty high average, but in the 1980s it would have been considered ridiculously low. It is a conservative estimate. If we assume by combining our floating interest rate from our Federal loan (60%) and Provincial loan (40%) we will end up with an average of about prime + 2% and we can crunch some numbers. With these variables the average interest rate on the life of your student would be 6.5%. This doesn’t represent the true cost of the loan though because of the student loan tax credit that you could claim on your taxes. For people in the lower tax brackets this will usually be about 17%. This drops your effective interest rate to about 5.5% and this is what we will use for comparison purposes.

From the various studies I found on the internet, the average university graduate is currently leaving school with about $23,000 in debt. Some estimates were higher than this, but I think it’s a decent comparison point. The length of the loan is obviously dependant on how quickly you wish to pay it off. I couldn’t find any info on the average amount of time graduates pay their loans off in, but most people are initially set up on 10 year plans. I think that this is another reasonable number to use for our little comparison.

So let’s take a look at how much it will cost in total for a 23 year-old university graduate to pay off their student loan of $23,000 by the time they are 33 at an effective rate of 5.5% interest. My calculations spit out $29,953, which is about what I expected. This means that it cost you roughly $7,000 in interest to take out that loan (more in dollars paid, but remember the tax credit you receive).

That by itself is a sobering figure; however, the comparison between no debt upon graduation and an average amount of debt is going to get even more lopsided when we factor in where that money could have gone.

Since it is assumed that in theory you could live your life the same way you did in our prior hypothetical situation and wouldn’t have to spend any more money, let’s say you took that 30K (rounded) and had put it in investments. The beauty of investing so young is that you can afford to invest in higher risk strategies because you won’t be tapping into that money for a long time. The higher the risk, the higher the reward. We’ll use another conservative long-term number and calculate our returns at 8% (the stock market as a whole has returned well over 10% since its inception). I’m also going to assume that we invest in tax-efficient registered accounts (such as TFSAs or RRSPs).

So if that same 23 year old took their $3,000 every year (this is all after-tax dollars since our student loans were paid with after-tax dollars as well) and put it in a TFSA and invested in a stock market index fund that returned 8% they would have just over $45,000 in their bank account when they turned 33. If you think this is ugly, it’s about to get even uglier. If we assume in both of our scenarios that the graduates both want to retire at age 60, the 45K that the no-debt graduate had at 33 will have compounded to about $217,000 (assuming a 6% interest rate to calculate for less risk as you get closer to retirement)! That’s a snowbird’s winter home in Florida right now!

This comparison is obviously very anecdotal. Students could have more or less debt and they could pay it off in a shorter time horizon (thus saving on interest). The students with no debt could choose to live a more luxurious life instead of investing the difference (as often happens). But all of that being said, we used fairly conservative numbers and the real difference in many situations is more likely to be higher than lower in my opinion.

In conclusion, after mashing all the numbers together our hypothetical average student will sacrifice well over $200,000 available at retirement because of their original $23,000 in debt that they graduated with. Ouch!

I am definitely no finance professional and as such I freely admit that I could easily have made a miscalculation at some point (although I think the basic principle is unchanged). Feel free to help me out with specific numbers if you disagree.