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Inflation’s Role in Debt vs. Save
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Let’s say you have a $25,000 student loan (what a coincidence, I have a nearly $25,000 student loan!) on which you’re paying about 3% interest, if you consolidated about two years ago, and you’re only sending in the minimum payments because you’re coming out ahead when you deposit the rest in a 5.15% Emigrant Direct account. This is exactly what I’d be doing if my loans weren’t in deferment because of my continuing education. (feel free to substitute car loan for student loan in the example, any low interest loan will suffice)
The only problem with that thinking is that while you are you coming out ahead by 2.15% (a little more considering the interest deduction), the difference between the 5.15% savings account and the 3% student loan interest, you’re actually falling behind from a purchasing power perspective because inflation is higher than 2.15%!
Now, if we were discussing this, you’d say that if you paid out the entirety of the loan as quickly as you could, you’d in fact be making 0% on that money because you would no longer possess it. That is true, however, by accelerating your payments you are setting yourself up to be debt free in the future and thus able to freely invest what you would’ve had to earmark for student loan payments. [Also remember that this superficial analysis ignores all other factors because we often can't make large payments on our student/car loans because we have other financial obligations like mortgages/rent, food, emergency funds, etc. that take precedence, but for the sake of argument from a strictly mathematical perspective I ask that you leap with me.]
So, how is this different than the 0% balance transfer arbitrages that many personal finance bloggers (including myself) have started? How does a 3% car loan differ than a 0% credit card loan outside of the interest rate? The difference is the 0% balance transfer is the source of the interest bearing funds whereas with a car loan the source of the interest bearing funds are your own savings. 0% balance transfer money is a bonus.
I’m eager to hear everyone’s thoughts on this because for the longest time I was of the mindset that you should just pay the minimums, deposit the rest, and collect your difference in interest because you’re making more than 0% on your money. The floor of what you should demand on your money should be the inflation rate, which is much more than 0%.
{ 17 comments, please add your thoughts now! }
You left out one very important variable. Student Loan Interest can be written off on your taxes. I did the same thing and each year, I save about $300 in taxes so it’s well worth it
What you’re basically saying in your above example is that on one hand you’re coming out ahead by 2.15% over the life of the loan, which is less than inflation, but you’re still earning that 2.15% … on the other hand you could pay the loan off faster and you’d only be making that extra 2.15% until the loan is paid, and after that invest what you would have been paying toward the loan into the high-yield savings. Is that correct?
If so, you can calculate how long it would take you to recoup that extra 2.15% that you would have earned had you not paid the loan off faster.
Note that student loan interest cannot be deducted if you make over $65,000.
You don’t have to worry about the purchasing power from student loan beacuse it not your money. Suppose you keep the money for certain time in bank account at 5.15% and pay 3% to loan then you are gaining 2.15% as against you pay off the loan.
e.g. if you make $515 as interest and pay $300 to the bank you still make $215 which you wudn’t have made if you pay the loan. I agree that what you made $215 is less than what “Student Loan” has devalued which is anyway not your money to worry for All you care for is $215 interest you got.
jim,
Inflation is the missing link in many return calculations. Regardless of the investment, the most conservative approach would to adjust your return downward for inflation. Using a nice round number, 3% inflation, your Emigrant account now earns 2.15%, meaning you are in fact losing money by not paying off the student loan. Similarly, your arbitrage gambit earns the same 2.15%, but you’re playing that against a 0% debt. You’re still a winner, just not as big a winner as before.
King Asa,
I’d restate the options this way (again, assuming 3% inflation): #1 – make minimum payments and lose .85% for the life of the loan. #2 – maximize payments, losing a full 6% for the shortened life of the loan, then invest at a positive 2.15%
What some are forgetting is that there is tax on the 5.15% savings account. So after taxes, the return is closer to 4%. Now, if you do not have the student loan deduction (income too high), then your 2.15% gain is down to 1% or less, close to break-even.
Yet, the real issue, is the other loans that you may have in the future. Are you going to buy a car? Need a down payment for a house? If so, then I would keep the student loan payments to a minimum and save up for the car or house, because I would rather have a 3% student loan than a 6%-7% mortgage or car loan in the next few years (use your savings instead to put a large down payment on the car/house).
Jim,
I’m not sure that your assessment is correct. Inflation is working for you by devaluing your debt and against you by devaluing your investment returns. The net impact is derived from the delta.
I’ll borrow the from the example from the anon comment above…
What we’re really discussing is the situation where you have money to make a debt payment. In particular, is it in your best interest to make the debt payment or to invest the money you have and make the payment later? Consider the nice, tidy example where you have $1050 and you owe $1050 with a minimum payment of $50. Conveniently, you have $1000 left that you can use to pay the loan balance or invest.
If you pay the balance now, then one year from now you will have $0 and owe $0 for an astonishing net of $0.
If you invest the $1000 at 5.15% and the loan rate is 3%, then one year from now you will have $1051.50 and owe $1030. Inflation has no impact on that calculation. At that time, you can pay off the full balance and have $21.50 left. Assuming that your loan interest is deductible, you will pay taxes only on the $21.50 net gain, leaving you with, say, $15 after taxes (depending on your tax rate). Now inflation rears its ugly head; not on your full $1050, just on your $15. Your $15 gain one year from now is devalued by the inflation rate (assume 3%), so that in today’s dollars, it’s worth only $14.56.
Of course, I’ll admit the possibility that I’ve misunderstood the situation you were describing, in which case my example is irrelevant. But given this scenario, the better move is to let inflation be damned and invest in that cush 5.15% bank account (unless the effort isn’t worth it to you for $14.56).
-James
James, you understood the situation perfectly correct and you do bring up a correct point that inflation is affecting both the debt balance and your own savings… something I completely forgot/ignored. Now I’m back to square one…
Maybe I’m being dumb, but how does inflation work for you? How is it devaluing the debt?
Even as the purchasing power of the dollar decrease over time as a result of inflation, your nominal debt balance remains the same. $10,000 owed in 1900 is significantly more than $10,000 owed today, that’s why inflation is “working for you” in that case.
When I deferred payment on my student loans, until I finish my MBA (and the interest isn’t accruing), the roughly $25,000 I owe will be “worth” less than it is now.
Got it! Putting the years to it did the trick. Just couldn’t get my mind around it for whatever reason.
Star Money Articles for the Week of Sept. 4
Here are interesting posts and news this week from the MoneyBlogNetwork members and beyond: Blueprint for Financial Prosperity discusses inflation’s role in debt vs. save. Consumerism Commentary highlights Consumer Reports’ unique approach. AllFina…
Alright, you’ve been peppered on this one pretty good already, but I agree with James, for the record. The inflation affects your ED account and equally effects your student loan account. The longer you take to pay off the *fixed* student loan, the less you end up paying in adjusted money value (inflation taken into account) since 25k paid now is worth much more in terms of buying power than the sum of the monthly paids needed to pay this off in however many years.
Mathematically, you can think of the total value here as the sum of two terms that change over time — your student loan and you savings. Both those terms have some constant infront that represents inflation. Since it is common, you can factor it out. This will cause the total value to change, no doubt, but it will never affect the difference between our two terms.
A = C*B – C*D
A = C*(B – D)
B-D is fixed, regardless of C (inflation). And, in fact, the best “B-D” will be best regardless of C.
I know this has been discussed elsewhere ad nauseum, but I still think for me the psychological benefits of being out of debt faster would outweigh that 2.15% gain I’d have if I saved the extra amount.
That said, I just stopped overpaying my mortgage so I could contribute more regularly to my E-fund. What can I say? Consistency is boring.
What some are forgetting is that there is tax on the 5.15% savings account. So after taxes, the return is closer to 4%. Now, if you do not have the student loan deduction (income too high), then your 2.15% gain is down to 1% or less, close to break-even. Think about it!
This is true. Another factor is by paying off the student loan faster you will improve your future debt-to-income ratio, which will enable one to obtain lower interest rates. There are a myriad of variables to consider.
Almost too many for me to think about. Every time I think I’ve got the system figured out, there’s another complicating factor!