Everyone knows there is a cost to hold debt which is the interest and fees on your loan accounts. These amounts are clearly marked on your statements or online banking. Since medical professionals receive preferred interest rates from banks, interest charged on student loans is typically around 3%. If your student debt is structured properly, the amount may even be tax deductible.
Paying off student debt, and all debt in fact, feels amazing. Because of this, it is often a financial goal for young professionals when leaving residency.
What people don’t talk about is the costs associated with repaying your debt. Your bank will tell you the amount required to discharge your loan are simply the principle amount owed plus accrued interest to date plus a discharge fee (likely $250). When you look at it this way, paying off your debt is very cheap and you benefit by reducing your monthly cash outflow by the regular payments. There is, however, one major expense that is not discussed when it comes to repaying debt. Tax.
What people don’t talk about is the tax cost to pay the debt. Now what do we mean by this? Why do I pay tax when I repay my debt?
Simply put, in order to pay off your debt you will need more cash monthly then to simply service the debt by making the interest payments. When you are building a financial plan the tax cost to meet your goals must be considered. If we use a simple example of having $200,000 of student debt when you finish residency and an assumed marginal tax rate of 50% then it will cost you $400,000 to repay your debt as you will need to pay $200,000 in tax in order to have $200,000 to pay off the loan.
When framed in this way, paying off debt may not make much financial sense as the $200,000 tax bill is a significant cost. By deciding to continue to pay your student debt (interest only) over the years you lost the opportunity to invest the $200,000 used to repay the loan and the $200,000 paid in tax. Over a 30 year period this one decision (to pay your LOC off) will result is you having less assets when you retire. If we assume a return of 3% (equal to the LOC interest rate) that will result in your investment account being approximately $850,000 lower then if you didn’t pay the LOC. This is an increase in your net worth at retirement of $650,000.