Wondering if your student loans are good debt or bad debt? If you had $50,000 of credit card debt without enough cash to pay it off, you might feel sick to your stomach. If you had a $500,000 loan on a $1 million business, you’d feel fantastic.
Some debt is unambiguously bad, while other debt can help you grow wealth. When it comes to determining the best and worst debt to have, how would we classify student debt under this framework?
Characteristics Of What I Would Consider Good Debt
I’m cool with folks letting good debt hang around, but bad debt needs to go as fast as possible with every available dollar dedicated to slaying it. Here’s are some tips on how to identify “good debt.”
If you have a student loan, it is NOT tax-deductible. Sure, there’s a $2,500 deduction, but that’s not applicable for higher income earners. Why is it important to receive a tax deduction for debt?
Assume you’re paying 5% interest, you owe $100,000 in student loans, and you live in New York City. Pretend that your combined tax rate is 40%. You have to come up with $5,000 just to pay your interest each year. However, because the interest is not deductible, you have to earn a lot more than that in salary. This formula shows how to calculate the “tax equivalent yield.”
0.05 / (1-0.4) = .0833 = 8.33%
This 5% student loan is like a savings account yielding over 8%, only in reverse. OUCH!
In contrast to student debt, mortgage interest and business loan interest can sometimes be tax-deductible.\
2. Backed By An Income Producing Asset
You could say the brain is the best asset out there. I’d agree that investing in your education makes a ton of sense. The problem is that the government lending programs for student debt have allowed millions to borrow more than double their expected incomes as professionals.
If you’re coming out of school with less than 2 times your expected income, I would give student debt a check mark on this test.
Another example of debt backed by an asset is a rental property. You expect the cash flow from rental income to eventually pay off the mortgage you took out, leaving you with a paid off house.
Business loans are often backed by an asset. Many of my dentist clients purchase their own dental practice, for example. Borrowing $800,000 for an asset that will likely increase in value over time and eventually be paid off is a good decision.
In contrast, I consider car loans and credit card debt to fail this test. Cars decline in value, and credit card debt just sucks. There is no income coming from either of these two kinds of debt, and they should be avoided if at all possible.
3. Increases Your Earning Potential
A lot of my readers ask me, “Hey Travis is it smart to borrow a bunch of money to become a pharmacist” (or physician, vet, chiropractor, etc.)
I say that it depends on what your alternative is to your chosen career path. If you would’ve been doing a corporate job somewhere making $60,000 a year instead of your career as a pharmacist making $120,000 a year, it’s reasonable to go to school to get that PharmD from a financial perspective.
However, if you take out $250,000 to become a chiropractor and earn $60,000 a year, then your earning potential was not increased by going to school and that’s one of the most common reasons to avoid student loans. The motivation for becoming a DC would have to be something else besides financial.
4. Minimal Impact And Stress On Your Life
What good is debt if it gives you ulcers? Some people are built to handle debt well and others are not. Personally, I’m extremely debt averse. We have a 2.8% variable rate debt and mathematically it probably makes sense to keep it around and invest instead.
The reality though is Christine and I want to have kids and explore alternative lifestyles other than full-time work for the rest of our lives. Because of that, we want the smallest recurring monthly bills possible. For us, that means we want to owe nada.
If you have debt that checks other boxes here and it doesn’t have a negative effect on your mindset, then you’re in good shape to let it stay around.
5. Low Interest Rate
At the risk of stating the obvious, if you have debt at a low interest rate, the risk is way lower. Some borrowers have written to me with 20 to 30-year student loans at a 3% interest rate. They got super lucky by getting to borrow under the old federal student loan system.
Most people expect that inflation long-term will run at least 2%. If your debt is anywhere close to that, then you’re almost getting free money. Most student loan borrowers though these days have interest rates between 4% and 8%. That doesn’t pass the test.
6. You’re Not Required to Pay It All
I had a physician client recently who received about $40,000 a year from the National Guard for her student loans. This payment would come in over time in exchange for a commitment to serve for a certain number of years.
Obviously, if you’re getting some kind of repayment benefit, you might as well maximize it. I would not hold off paying down debt if it’s a token amount from an employer.
Another consideration is if you could benefit from going for loan forgiveness on PAYE or REPAYE over 20-25 years. If the cost in today’s dollars is low enough, you might benefit enormously from letting the debt hang around making this one of the reasons why having student loan debt isn’t so bad. This is even more true for borrowers getting tax free forgiveness under PSLF.
The Answer: Student Debt Can Be Both Good or Bad
Would you consider your student loans good debt or bad debt? Here are a couple real-world examples. I promise this isn’t a “take no position” cop out.
Deb the Lawyer
Pretend Deb has $50,000 of private student loans at a 6% interest rate. She makes $120,000 as an attorney.
Her debt is:
- Not deductible (she makes too much for the 2500 deduction)
- She has to pay all of it because it’s private
- Fairly high interest
Given this debt is “bad debt,” Deb should refinance these loans to a 5 year and pay it down rapidly. She might be able to crush it in less than 2 years if she focuses on getting rid of this nuisance debt.
Hailey the Veterinarian
Hailey owes $300,000 from vet school. She is wondering whether she should focus all her energy on paying it all down as fast as possible. Assuming she does not have a spouse’s income to consider, Hailey would be an excellent candidate for a loan forgiveness strategy over 20-25 years.
That means her debt is:
- Going to be partially forgiven
- Not a danger to her monthly cash flow because of income-driven repayment
- Not practical to pay down rapidly
Hailey would be better off maximizing her retirement plan and saving in a brokerage account for the eventual tax bomb at forgiveness.
Sean the Dentist
Sean went to an in-state dental school and owes $250,000 of student debt. He is earning $150,000 as an associate dentist in Texas. He wants to buy his own dental practice in the next year.
The math of this case will lead to Sean wanting to eventually pay the debt down because he will not get anything forgiven with his rapidly increasing income, especially when he buys the dental practice.
The student debt needs to go because:
- His business debt for the dental practice will be deductible, but the student debt will not be
- His income is too high for income-driven repayment long term, which means none will be forgiven
- Paying aggressively on the debt will not inhibit him from making investments in his business or living a comfortable lifestyle
Sarah the Physician
Sarah is concerned that she won’t receive Public Service Loan Forgiveness because of the new laws the GOP Congress is considering. She’s been thinking about refinancing it all because of the stress of having such a large burden that continues to grow.
Hopefully, Sarah why her student loan debt can be good because:
- The projected forgiveness that happens will be tax-free
- The cost of allowing the debt to continue to accrue interest is minimal compared to the savings possible
Figure Out if Student Debt is Good or Bad in Your Life
If I’m honest, I don’t like terms like “good debt” and “bad debt” because they’re squishy. The reality is there are 2 plans that make sense for your student loans. Pay them down as aggressively as possible like your life depended on it, or strategically pay them as slowly as possible.
Once you realize how these tips relate to the debt you have, you’ll be prepared to attack or manage your debt accordingly. Of course, we can always figure out your options for you.
Have you ever decided to keep debt around? Any experience with bad debt in your life? Feel free to share.