Dealing With Debt After College
I recently had an email conversation with my neice about helping one of her college-graduate friends manage their college-related debts. Since the average student graduates with tens of thousands of dollars of debt, you will likely know somebody who could find value in the following answers to her questions.
Uncle John -
One of my mathematically challenged graduate student friends has asked me to help her figure out a budget sheet so she can set out a plan to get out of massive quantities of student debt. It seems pretty simple, so I said I'd help out, but I had a couple of quick questions for you--if it's not too much of an imposition, since this is pretty much what you do. (Although I think you help people make money, rather than keep the bank from taking their money).
Actually my work is both in helping people with their investments AND getting control over their cash flow. Lots of people think that you create wealth only through investment accounts. In fact, many give up on their own personal finances because they "don't have any money to invest so a financial planner can't help me" (Sad but true).
The most potent wealth building tool a person has is their cash flow. Managing the money slipping through your fingers each month is far more powerful than anything an investment advisor can do for you.
Factors: she owns a house (with a mortgage); she's got some student loans that won't charge interest for 5 more years; she's got some non-student loans that are charging interest now.
I have 3 questions:
1) The house vs. student loans that are going to charge interest. Mathematically, she pays down the house because she is already paying principal and interest on it, then sells the house when she graduates and puts a huge lump sum toward the student loans. How risky is that plan?
That plan is not too risky. I prefer to see people pay ONLY the interest on the mortgage (provided this is allowed by their mortgage contract) and then put whatever they were going to pay towards principal into an investment account. This creates liquidity - once you've paid the bank that equity, you can't get it back out without asking for a new loan ... a problem if you lose a job, can't find a job or become disabled. When that money is put into an investment account instead, it is liquid and available should you need it and will grow if you don't. We find that people who follow this strategy can retire a mortgage in 23 years with the same cash flow they would put into a 30 year mortgage.
Of course, this strategy only works if the person has the discipline to look at those principal payment diversions with the same level of obligation they do to their payments to a bank. It's easy to say, "just this month I'll give myself a break and spend the money instead."
The risk in your strategy is that the house will go down in value or they will not be able to collect enough in rents to cover the nut. I don't know if the mortgage is on a variable rate or fixed. Interest rates will be going up in the future, so a variable rate loan could create some problems, too.
My recommendation would be to pay as little as possible on the mortgage, nothing on the student loans that haven't kicked in yet and every spare dollar goes to retiring the high-interest credit card debt. I would also like to see her build up a cash reserve of 2-3 months expenses, too - even if that means cutting back on those non-student loan payments somewhat.
2) She rents rooms in her home to other graduate students. Obviously, for the home to be a good investment, the cumulative rents need to cover property taxes, home insurance, interest paid on the mortgage, and home repairs--so that at least she isn't paying more than it would cost her to rent an apartment elsewhere. Beyond that, though, what should she expect to make on rents for the home to be considered a good investment or at the very least to cover her risk?
Ideally, if she weren't living in the home and someone else was paying rent to fill her space, the total return after all property taxes, insurance and a modest repair and maintenance allocation on a decent investment will be netting AT LEAST 7-8% return on equity - but that is for an un-leveraged investment (no mortgage). With the risk that comes with leverage (you have to pay the mortgage even if you don't have renters paying you), the "cap rate" (net income after all fees including the mortgage and taxes) should really be closer to 13% per year or higher.
How many people have investment real estate with this kind of return? Not a lot. I am just using the standards of what could be achieved if that equity was deployed someplace else.
3) I've always used the rule: you pay down the loan with the highest interest rate first. Do you ever break that rule? Is this question retarded?
There is no such thing as a retarded question - it is a good question and a good rule to use. Make certain you are comparing apples to apples. Some debt is tax-deductible, some isn't. Compare interest rates after taxes.
I also will reiterate my point about liquidity - there is much to be said for diverting money that could be used to pay down a low-interest loan and putting that money into a well diversified and appropriate investment account (provided you have the discipline to stick to the investment strategy and the tolerance for shorter term value fluctuations). I can't tell you how many times I've seen people of all ages pay off a loan and have nothing left when they really needed the money ... and they can't borrow it back because now for whatever reasons, they don't qualify.
PS Have you run into the Evangelical Dave Ramsey's "Financial Peace University" program? Do you have an opinion on it? All my friends here seem to swear by it.
Dave Ramsey has been around the personal finance self-help arena for many years. In general, I applaud his ability to get people to address their debt issues and be responsible for their spending. The debt snowball method certainly works, especially for people who have no self control (which is a large number of Americans these days, I guess). He has done a lot for financial literacy awareness.
I do disagree with the statement that a person should always do everything in their power to be debt free. In the grand scheme of things, I just don't see it that way.
Sure, getting rid of 15% interest rate credit card debt is good. But accelerating house payments on a fixed 6% mortgage is patently wrong in my book. After taxes, that 6% loan is really only costing you about 4.5%. In addition, if you wait 15-20 years to pay off the loan balance, you will be using inflated (relatively worthless) dollars to pay off a contract that is valued in today's more valuable dollars. Inflation helps debtors and punishes savers. We are a debtor nation, especially those in government. They will do everything in their power to make sure we have inflation.
I know Dave and others illustrate how much money you pay in interest payments over the life of the loan. It is not a fair or truthful illustration. What they neglect to point out is that every dollar you put into paying down that debt cannot be invested somewhere else. This is the basic economic principle of Lost Opportunity Costs. A well managed investment portfolio should be able to beat inflation by 4-5% with limited risk. Mortgages today have an interest rate that is only 2-3% above inflation.
Should you pay down high-interest debt? Yes. Should you spend the money on stuff rather than paying down that mortgage loan balance? No, that's stupid and self destructive. Should you invest that money and get 6-7% in return rather than pay down the mortgage which costs you net 4.5% in real interest ... and then put yourself in a position where you have no cash reserves should something happen and you need the money?
I don't think so ... but that is just my opinion based on my experiences and those of my clients whom I have seen suffer through the consequences.
I hope this helps. Let me know if you have more questions.
Best Wishes,
Uncle John