Background

Student Loan debt is one of the 3rd rails of financial planning for attorneys. The debt you likely incurred during your undergraduate and/or law school years may feel enormous and can trigger very real emotional reactions. People don’t like to be in debt, and it often casts an ominous cloud over those that owe money to a lender. Those feelings are very real, very justified, and very normal. It is a good instinct to have to want to avoid getting into or staying in debt.

Student Loan debt is also frequently misunderstood. Student Loan debt is not like other “traditional” debts, where interest is periodically added to the principal balance of the loan, generating interest on interest, until and unless the loan is fully paid off. The misunderstandings around how student loan debt is different than traditional debt can lead to errors in repayment strategies that could cost student loan borrowers thousands of dollars over time.

This blog will focus on what I believe to be an under-utilized repayment strategy that will give you a satisfying way to arrive at a balance between student loan repayments and long-term investment savings.

You Can Balance Student Loan Payments and Saving for the Future

There are two fairly simple, well-known strategies for paying off student loan debt. One of those is making the minimum payments, and the other is paying down your debt aggressively at the expense of less important goals or even delaying milestones in your life like buying a house or starting a family.

A third strategy that I don’t see discussed often is this: Make your student loan payments an “asset class” within your overall investment portfolio. This is more complex, but you’ve handled complex. Let’s look at a hypothetical example:

First, let’s assume you have federal student loans with an interest rate of around 6-7%. This means that every excess dollar you pay down in principal each month is “earning” a 6-7% return in terms of the future interest you won’t be paying*. That is a healthy return, considering it’s guaranteed (when you pay down that extra $1 in debt principal, it does not generate the 6-7% future interest that would otherwise be attached to it**). Of course, if you refinance into a private loan at a lower interest rate, the principles outlined below can still apply to paying down that debt too.

How does that guaranteed reduction in future interest payments compare to your investments? Well, it depends. In aggregate, across a diversified portfolio of stocks and bonds, you might hope to achieve at least 6-7% annual returns over the long-term. However, that same diversified portfolio should have underlying components that are expected to generate more or less than that hypothetical average of 6-7%.

This is where the “complexity” kicks in. Take a look at the holdings in that overall portfolio. Are any of them in lower-risk asset classes that may have a lower “expected return” (this is a financial term, and it doesn’t necessarily mean that we literally expect a specific return number in real life) than your 6-7% interest student loans? If so, it may make sense to allocate the investment dollars that would be going to the lower expected return sleeve into extra debt payments on the student loans.

Of course, there are pitfalls with this strategy just like any other. For one thing, you don’t want to over allocate payments to your student loans in the context of your overall investment portfolio. For example, if you re-allocated all the dollars that should be going to bonds and put them toward student loans, then you’ll have nowhere to draw from if stocks decline and you need to rebalance. Along the same line of thought, student loan payments can’t be taken back. Once you pay the debt payment, that money is gone. It’s important to maintain adequate liquidity in case of emergency when you’re paying back your loans as part of your broader strategy.

*Not all student loan interest is “capitalized” (added to the principal balance of your loan to generate new, compounding interest). Your loans may be “subsidized” and/or interest may not be capitalized until a triggering event, such as consolidation within the federal system.

**Again, assuming your interest is capitalized and starts generating extra interest itself. This may not be the case.

Summary

Student loans are complicated. They’re weird. They don’t work the same as other debt. Anybody that thinks student loan debt is just like any other debt doesn’t know what they’re talking about, and that should be a red flag for you if you’re seeking out advice on what to do with your loans.

When it comes to paying down your debt, you can balance your student loan payments and your long-term goals. Think of the interest charged on your loans as a “guaranteed return” you can earn by making extra payments toward your loans so that the interest on those dollars does not accrue and capitalize, generating interest on interest. In this way, you can compare the risk/return characteristics of your student loan payments (low-risk, moderate return) to other asset classes in your diversified portfolio, and potentially opt to allocate dollars to extra payments on the loans instead of a different asset class with a less attractive risk/reward trade-off.

In doing so, be sure not to overdo it by leaving only high-risk assets in your investment portfolio. This will reduce your ability to rebalance when markets are volatile, and it may also reduce your available liquidity as unexpected needs arise. Always ensure you have an adequate emergency fund in place and leave some lower-volatility assets in your investment portfolio (low-risk bonds) so that you have the ability to rebalance in the event of stock market volatility.

It’s all about balance, and this can be a very satisfying way to know that you are being smart about how you balance student loan repayment and saving for other goals.

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