Sunday, August 29, 2010

Good Debt

Who we are and where we come from shapes our financial attitudes more than we realize. Sometimes this is good (e.g an immigrant tradition of frugality) but sometimes less so - and in my life this has manifested itself very strongly as an aversion to debt. I came to the US as a child, and neither I nor my family understood that not all debt is bad. While I am ecstatic to be debt free, looking back, I see a missed opportunity to have taken on good debt. As Chef says, there's a time and place for everything, and it's called college.

By the time I started college, I had enough money saved to pay for a few semesters' worth of room and board. While in college, I had up to 3 jobs at a time and made enough to support my education and even save something. Consequently, it never crossed my mind to take out student loans - there was no need for it and I felt pride not needing help.

I have at times wondered what that pride has cost me, and wanting to give substantial advice to the 18 year old asking for it at GetRichSlowly, I crunched the math.

If I had taken the loans out, I would still have worked and earned money. But this money could have been invested at interest rather than going to the school. Foregone interest on these funds is the opportunity cost of not taking the loans. For those interested in the math, it's bellow, but the short answer is: I would have been $2,723 richer at the time I graduated in 2003 had I taken the loans.

My credit score would have benefited as well from having history of borrowing and repaying a loan.

So long story short - debt (especially subsidized debt!) can work for you if you have the knowledge and discipline.

How I arrived at the $2723 figure. The following math calculates the interest that would have been earned if I had borrowed interest-free and invested my own money at the prevailing CD rate each of the 4 years of my undergraduate education.

Freshman Year, 1999
  Max Loan:               $3500
 4 year CD rate in 1999: 5.95%
 Value of CD in 4 years: 3500 * 1.0595^4 = $4410

Sophomore Year, 2000
  Max Loan:               $4500
 3 year CD rate in 2000: 7.339%
 Value of CD in 3 years: 4500 * 1.07339^3 = $5565

Junior Year, 2001
  Max Loan:               $5500
 2 year CD rate in 2001: 5.181%
 Value of CD in 3 years: 5500 * 1.05181^2 = $6085

Senior Year, 2002
  Max Loan:               $5500
 1 year CD rate in 2002: 2.956%
 Value of CD in 3 years: 5500 * 1.02956 = $5663

Total Value of CDs:  4410 + 5565 + 6085 + 5663 = $21,723
Total Loan to Repay: 3500 + 4500 + 5500 + 5500 = $19,000
Interest:            21723 - 19000 = $2,723

Sources of data:
Subsidized loan limits:
CD Rate history:

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