Debt Part 2 - Student & Personal Loans
Student Loans
Student loans have become a major issue in the United States, and with 54% of college students borrowing money to pay for their education, chances are you know the burden first hand. If that’s true, then the name of the game for you is tax deductions.
The federal government allows you to deduct up to $2,500 of interest expenses per year from your taxable income if your MAGI (modified adjusted gross income) is less than $65,000. If your MAGI falls between $65,000 and $80,000, you can deduct a portion of the interest expenses. Unfortunately for anyone with a MAGI higher than $80,000, no deductions are allowed. (MAGI is one way the IRS determines your income, it’s pretty confusing but most CPA or tax filing software (i.e. TurboTax) will handle these calculations for you).
You, like most people, probably had to take out student loans while you were still a student with a low income and little-to-no credit history. As such, the lenders probably gave you a pretty sh*tty interest rate. It may be worth your time to see if you can refinance those old loans at better rates, especially if you have improved your income and credit score after graduating. Most major lenders will be happy to have your business, and a one percent rate reduction over the life of a $50,000 loan can easily save you $3,000 - $4,000.
(If you are wondering how to improve your credit score, consider our Guardian credit builder savings account 😉)
Personal Loans
Finally, we come to the most ambiguous type of debt for a consumer: the personal loan. A personal loan is when you borrow money for personal reasons, which could range from consolidating existing loans to buying a brand new curved 4K TV.
Here is a rule of thumb for taking out a personal loan: only use personal loans if you can justify it as an investment (unless it is an emergency or necessary situation). To understand what we mean, consider a few reasons for getting a personal loan:
Debt consolidation: You have $5,000 in credit card debt and $35,000 in high-interest loans from a previous rough time, charging you 17.86% and 9.8% respectively; you take out a personal loan for $40,000 at 8% to pay them off.
Home renovation: You borrow $15,000 to add another bedroom to your two-bedroom house, and you know that 3 bedroom houses typically sell for $25,000 more than 2 bedrooms in your neighborhood.
Discretionary Spending: You take out a $4,000 loan for a 77 inch LG 4K TV to replace the 60 inch Samsung from your college dorm room.
Option one and two are generally good uses of personal loans because they help you grow your net worth. The debt consolidation lowers the cost of your loans by replacing multiple high-interest rate loans with one lower rate one, reducing your monthly payments to save you money; the home renovation appreciates the value of your home more than the amount you borrowed, a move that creates more wealth than the cost of the loan.
Option three is generally a bad purchase. With the average personal loan charging a 9.41% interest rate, that’s a high price to pay for something that won’t generate any returns to offset the cost. If you are planning for a wedding or some other big-ticket item that won't generate a return on investment (ROI), then it would be wise to start saving towards that purchase as early as possible, so you can avoid expensive and wealth eroding debt in the future.
Uses for Loans & Debts
Loans can pay for themselves if you’ve used the borrowed funds to lower your financial liabilities or increase your wealth, both of which results in an increase to your net worth. When done properly and managed carefully, debt can be an amazing way to responsibly accelerate your financial journey. Here are some debts that generally fall in this category:
Mortgage: a sensible house purchase financed with an affordable 15 or 30 years fixed rate mortgage can be a great financial and personal decision. If you’ve done your research on the house, neighborhood, and pricing, there’s a good chance the house will not only be your home, but also an amazing investment (we will go into more details when discussing different types of investments).
Refinance: if you can refinance an existing loan with better terms such as a lower interest rate, it's generally a great way to increase your net worth by decreasing your total amount owed.
Debt consolidation: as we mentioned when talking about personal loans, this is another way to ease the financial burden on yourself that can lower your monthly payments without increasing the total loan amount.
Investment: the careful and thoughtful use of debt for good investments can be one of the best ways to grow your fortune. However, a bad investment financed by debt can seriously damage your personal finances so we urge everyone to think twice before using debt to make investments. We will discuss this in more detail when talking about investments, and focus on the risks you must watch out for if you consider this option.
Sometimes, loans can also help you grow your net worth indirectly. This may not be as simple as "take out a loan, renovate your house, and profit through increased home value", but it doesn't mean it is not worth considering.
Think about buying a car, or a new MacBook Pro. These are pricey purchases that might be essentials; the car lets you move around and maybe your old laptop is falling apart. Just because there isn't a direct economic way for these purchases to pay for themselves does not mean you can’t finance them with debt.
For example:
Imagine the Apple store was offering a $1,500 MacBook with zero dollars down, to be paid back monthly over 2 years with 0% interest. This comes out to $62.50 per month ($1,500/24 months).
Being the financial wizard you are, you put that $1,500 into an investment that has a conservative (very achievable) annual ROI of 5%.
At the end of the 2 years, the $1,500 you invested is now worth $1,653.75; that is $153.75 more than the $1,500 price for the MacBook, which means you essentially scored a 10% discount for your purchase, neat right?
The effect of this trick scales as the purchase price increases and is a common practice among wealthy individuals to essentially create "discounts" on large purchases. Imagine giving yourself a 10% discount on a multi-million dollar house, the savings can quickly add up.
Please note that this only works if the interest rate you pay on the purchase is lower than the ROI you can get by investing that money elsewhere; in the above example, if Apple charged a 5$ interest rate for purchasing the MacBook through installments, it would wipe out the benefits we mentioned, and any rate higher than 5% will result in you paying extra!
Repaying Debt
If you have debt charging you over 3 or 4% per year, paying them off quickly is almost always a good idea as the longer you keep the loan, the more interest you have to pay.
There are a lot of methods floating around on the internet regarding how you should pay off your debt, ranging from helpful to downright terrible. We will highlight two methods, the Snowball Method and the Avalanche Method.
For the Snowball Method, make a list of all debts you don’t want to keep (again we suggest anything above 3% - 4%), and rank them by loan balance from smallest to largest. To pay them off, make the minimum payment towards all of them, and put any extra cash towards paying down the smallest debt. Once that is paid off, move onto the second smallest, and continue down the list.
The Avalanche Method is very similar, the difference being that this time you are ranking them from the highest interest rate to the lowest, and focusing your extra cash towards paying down the highest interest debt. Once that is paid off, move onto the second-highest interest debt, and continue down the list.
We at Guardian like the Avalanche Method since it is mathematically designed to avoid paying extra interest. The Snowball Method, which is favored by people like Dave Ramsay, will provide a stronger sense of accomplishment as you cross off those smaller loans early on, but at the cost of higher total interest payments over time.
Up Next…
Now that you know the basics regarding the most common forms of debt, how to use them, and how to pay them off, it’s time to talk about the piggy bank. Follow us as we discuss how to save money…
