In a recent article, Noah Smith takes the view that millennials would do well to focus on paying off their student loans. He declares that repaying their student loans would yield better results than investing in stocks or homeownership.
Millennials and their Finances – What the Numbers Reveal
A recent study by Wells Fargo revealed that:
- About 52 percent of millennials are “not very confident” or “not at all confident” about investing in the stock markets
- Only 49 percent of millennials mention that they are saving for their retirements
- About 64 percent of millennials said that they financed school through student loans and,
- Over a third (36 percent) of millennials listed student loans as their biggest financial concern
Another survey by UBS Wealth Management concurred with this observation. It revealed that millennials invest 59 percent of their assets in cash and bonds, while investing only 28 percent in stocks. In comparison, the figures for non-millennials stood at 38 percent and 46 percent respectively.
Investing in Stocks – Ideal for Younger Investors and Better than Homeownership
Stock market experts have typically held the view that younger investors have the ability to take greater risks when investing their assets in the stock market for their retirement. This is especially the case because their retirement years are usually decades away.
Smith mentions that the millennial generation probably avoids investing in the stock market because they witnessed one of the greatest financial crashes in history on attaining adulthood. Other experts, including Morgan Housel, have testified to this as well.
In his column, Housel wrote that until recently, American under the age of 35 years did not save adequate sums of money or consider investing in stocks. He explains it by referring to the data compiled by Yale University economist Robert Shiller. According to Shiller’s data:
- An investor born in January 1980, who invested $1,000 on turning 18 years of age in the stock market, would receive just $1,030 on turning 30 (including dividends adjusted for inflation)
- On the other hand, an investor born in January 1970, who invested $1,000 on turning 18 years of age in the stock market, would receive just $5,400 on turning 30 (including dividends adjusted for inflation)
Shiller’s data also reveals that since 1871, the stock market has yielded an average annual return of 6.8 percent (after inflation). This period witnessed 29 recessions, a Great Depression, two world wars, various financial crises and multiple market crashes.
Yet, Housel writes, an annual return of 6.8 percent a year serves as a worthwhile benchmark. He mentions that a person who starts investing at the age of 22 years will receive $16.90 per dollar saved by the time the individual becomes 65 years of age at 6.8 percent compounded annually. Similarly, if the same individual starts investing at the age of 50 years, the individual will receive only $2.70 per dollar saved by the time the individual turns 65 years. Nevertheless, millennials follow a risk averse policy, when it comes to investing in stocks – despite having age on their side too.
In this backdrop, Smith writes that investing in stocks is preferable to homeownership. According to him, owning a home restricts your geographic mobility. As a result, it renders the homeowner susceptible to local downturns.
For example, if the city in which you stay starts experiencing bad times, you will face a higher probability of losing your job or enduring a pay cut. At the same time, the value of your house will also start declining. Therefore, while homeownership has its merits as part of the American dream, it does not quite make the cut as far as a financial investment goes.
Repaying Student Loans – An Investment Alternative for Millennials?
However, Smith highlights another worthwhile investment alternative for millennials i.e. paying off their student loans. Recently, the Federal Reserve Bank of New York declared that student loan debt is the only form of consumer debt to have grown since the peak of consumer debt in 2008. At present, the balances of student loans surpass those of auto loans and credit cards, making it the largest form of consumer debt apart from mortgages.
Smith writes that millennials often have huge amounts of student loan debt. This debt comes with high interest rates, ranging from 4.66 percent (for Direct Subsidized Loans and Direct Unsubsidized Loans) to 7.21 percent (for Direct PLUS Loans). Therefore, by paying off $1,000 of student debt at seven percent interest, millennials would be achieving an effective return of seven percent.
Therefore, if the interest rate on your student loan is 4.66 percent, then investing in stocks will give you better returns at 6.8 percent. However, if your interest rate is 7.21 percent, Smith mentions that repaying your student loan might be better than investing in stocks.
He writes that stock investments can be risky, as stocks can crash. However, repaying student loans is both risk-free and offers better risk-adjusted returns as compared to stocks. Therefore, Smith concludes, paying off a student loan makes for a viable investment alternative. Yet, this is where it gets interesting.
Student Loan Repayments Vis-à-vis Security Investments
Paying off a student loan is not the same as receiving seven percent interest. This is because the interest you save does not receive an annual compounding. When you make a monthly payment toward your student loan debt, a portion of your payment goes toward the interest, while the remainder goes toward the principal. With each payment you make, the interest component decreases.
As a result, the quantum of potential interest that you could save in the future keeps decreasing with each payment you make. Moreover, if you keep making payments on time, the amount of interest that you could potentially save remains more-or-less fixed.
In contrast, if you invest in a security that offers seven percent interest, you have the option of reinvesting the return. Moreover, the return will keep rising with each reinvestment, if you avoid withdraw the balance available. Therefore, opting to repay your student loan entirely will make you debt free faster. However, it might also leave you short of funds for dealing with emergencies that arise.
A Helpful Hand – Loan Forgiveness Options for Millennials Availing of Income-Driven Repayment Plans
In addition, new borrowers of federal student loans (i.e. people who take out federal student loans on or after July 01, 2014) have some recourse under the income-driven repayment plans. These repayment plans make student loan debts more manageable by reducing the monthly payment amounts.
|Income-Driven Repayment Plan||Payment Amount||Repayment Period|
|The Income Based Repayment (IBR) Plan(For those who are not new borrowers on or after July 01, 2014)||Approximately 15 percent of the borrower’s discretionary incomeNever more than the 10-year Standard Repayment Plan amount||25 Years|
|The Income Based Repayment (IBR) Plan(For those who are new borrowers on or after July 01, 2014)||Approximately 10 percent of the borrower’s discretionary incomeNever more than the 10-year Standard Repayment Plan amount||20 Years|
|The Pay As You Earn Plan||Approximately 10 percent of the borrower’s discretionary incomeNever more than the 10-year Standard Repayment Plan amount||20 Years|
|The Income Contingent Repayment (ICR) Plan||The lesser of the following:- About 20 percent of the borrower’s discretionary income or,
– The amount computed according to a repayment plan with a fixed payment over 12 years, adjusted according to the borrower’s income
Under these repayment plans, the federal government repays any remaining loan balance on the borrower’s federal student loans, at the end of the repayment period. In addition, borrowers could qualify for loan forgiveness under the Public Service Loan Forgiveness (PSLF) Program too.
Millennials and Indirect Stock Investments
The numbers cited earlier in this article highlight that millennials avoid investing in stocks. Yet, this is not entirely true. Millennials usually avoid investing their assets in stocks directly. However, when it comes to indirect investments, the reverse is true.
The increasing number of companies that are enrolling employees in 401(k) plans has resulted in about 70 percent of people born from 1979 to 1996 saving in a retirement fund. For many of these individuals, Housel writes, retirement funds form the bulk of their investments.
Housel cites data from fund giants such as the Vanguard Group and Fidelity Investments. This data reveals that a substantial portion of these savings automatically end up as investments in target date funds. Target date funds typically hold a large portion of stocks when the investor’s retirement is decades away. Thereafter, they demonstrate greater levels of conservatism by increasing bond holdings. Thus, without having to lift a finger, many millennials are investing their savings in stocks, albeit indirectly.
Whichever way you look at it, getting rid of your student loan debt is an attractive proposition. However, it might be worthwhile enduring it for some more time – especially if you don’t have enough of ready cash to fall back on in times of emergency. Ideally, you should invest some of your assets in stocks, stash some of them away in emergency funds and make your loan payments on time. With investments, as with life, following a balanced approach is the best strategy.