College is expensive, and fees and tuition continue to rise faster than the rate of inflation as reported on College Board Survey by Christian Science Monitor, August 13, 2013. Many students graduate with large amounts of debt that will take many years to pay off. Keeping up payments on student loans compromises their ability to live where they wish and do what they want during the early career years which are traditionally a time for exploration. (It is tempting to simply default on these loans, or try to, but the results can be disastrous. At the end of this article, we’ll explain why.)
However, what about using your investing profits to pay off student loans? If you are a recent graduate with strong cash flow and success in the markets, is this something that makes sense? Or, what if you are the parent or grandparent of a recent graduate and want to help them get out from under their mountain of debt?
The first thing you should know is that the first $2500 of interest on qualifying college loans each year is tax deductible, on IRS Form 456. What’s more, the deduction comes directly off income on the Schedule 1040—there’s no need to itemize deductions and file Schedule B. This is as close to “free money” as the IRS is ever likely to offer you. Assuming the recent graduate is in a bracket where they are paying some taxes, there’s little reason to pay off the principal prematurely. (This does NOT mean you should fail to make all payments when due; skipping payments can have negative effects on your credit rating and may move you into a higher interest loan.)
If you have positive cash flow, and you were tempted to accelerate payments to get out of debt, consider putting some of that money in the investment markets instead with the idea of paying off the loan in the future with your profits. With the interest deduction, you have just lowered your declared income by $2500. Work overtime and make an extra $2500, and you are back where you would be without the deduction, and paying taxes on that $2500 at your marginal tax rate. Make $2500 in the markets and it will be taxed at long or short term capital gains rates, which are likely to be lower.
Now, what if you pay more than $2500 in interest per year—something that is very possible with today’s college costs—so you no longer qualify for the deduction on the full amount of your interest payments? It may still make sense not to pay down the loan, depending on your interest rate. According to the official student aid site of the U.S. Department of Education, the current rates for undergraduate loans can be as low as 3.86%. Perkins loans have a 5% interest rate. Stafford loans, made in previous years, can also have lower than market rates compared to personal loans not secured by real estate.
So, if based on your experience and skill level you are comfortable planning for a 12% gain in your investments (to give a hypothetical number), you will still end up ahead even after paying capital gains and paying the nondeductible interest on that 3.8% or 5% loan. (The same numbers apply if you are a parent or grandparent who wants to help a graduate; you would not qualify for the initial $2500 deduction since it is not on your return.) Obviously this is an aggressive strategy since there’s no guarantee your portfolio will continue to see the same results as in the past. The numbers can work, if it does.
What if you are a parent or grandparent planning for future college expense, and you want to keep that future graduate’s debt as low as possible? There are a number of options open to you. The best known is the state-run 529 Plans which earn interest or market profits free of Federal taxes (and sometimes state taxes as well) so long as the money is used for education. However, there are many restrictions on 529 plans that may not be attractive to a self-directed investor, the most onerous of which is that you can only put the money in mutual funds which are set up especially for this purpose.
You could also make gifts up to the allowable amount each year ($15,000 in 2014) and avoid gift tax while giving the student the opportunity to invest the money and pay taxes on gains at their presumably lower tax rate. You will also be giving up control of the money, so if they decide to buy a car instead of save for college there’s nothing you can do about it. A better option may be to hold onto your money until they get into college and then pay their tuition. There is no gift tax regardless of the amount of this gift so long as it is paid directly to the institution.
Finally, what about simply defaulting on a college loan? People of baby boomer age may know someone who did this successfully; at one time record-keeping was primitive (and done with paper), enforcement was lax, and ultimately some institutions decided to just write off the loans as uncollectible.
However, this strategy is obsolete because of far tighter enforcement today, and the electronic databases to ensure you can no longer slip under the radar. According to finaid.org you cannot get out of student loan payments even if you declare bankruptcy. You will still have your wages garnished, suffer from a poor credit rating and be legally obligated for collection expenses—and you will still have to pay the full amount of the loan. Their article “The Horrors of Defaulting on Education Debt” contains a number of chilling first-person stories. Just do not do it.