Debt Reduction Case Study

Currently, over 40 million Americans now have student loan debt. Carrying tens of thousands of debt has almost become the new norm. According to cnn.com, “In 2008, only 29 Million consumers carried student loan debt. The balance has also shifted from an average loan size in 2008 of $23,000 and now the average loan balance is over $30,000.”

The total student loan debt is over 1.2 trillion and climbing. Unlike any other kind of debt, student loan lenders are continuing to provide loans to borrowers so young to where they do not have a proven financial track record or a substantial credit history. The only positive is that this can improve their credit score, as long as they pay it back on time. However, there is a 3 year default rate on student loans of 13.7% and there is over $450 billion in delinquency.

Enslavery to the lender has hindered the ability for Americans to save and lose precious opportunity for their capital to work for them. This has kept them tied to banks and using credit as a means for accessible financing. People are taught out of college to focus more on their liabilities and credit score, while their ability to build assets is further delayed.

Therefore, let’s look at a strategical way to pay off debt while not losing our ability to build assets. We will do this by taking an objective look at two different ways to pay off student loan debt. The objective of this real life case study is to improve consumer’s financial landscape while also not being in slavery to a lending institution.

Scenario (Actual Case)

John, 31, is a physical therapy assistant that has recently graduated from getting his masters degree. He currently earns a base salary of $65,000 plus an additional $20,000 of bonuses every year. He is looking for a plan to reduce his student loan debt while starting to save for his long term financial goals. John currently has an excess of $1000 a month available to utilize for his debt reduction plan.

John’s current liabilities are a $165,000 mortgage at 4.125%, student loans of $93,000 at 7.5%, and a truck note of $20,000 a 2.89%. Because of the low interest rate on his mortgage and truck, paying that off is not going to be his current focus. However, he views the management of his student loan debt to be paramount in his short term financial plans. Below is a table of his loan types, debt balance, interest rates, and monthly payments to each debt.

Loan Types Balance Interest

Mortgage $165,000 4.125% $799
Student Car Debt $20,000

2.89 Rate
Monthly payment $430
$93,000 7.5% $655

The traditional way of paying off debt is commonly referred to as the “debt snowball effect”. In this method, John would add his excess $1,000/month to the $655/monthly minimum student loan payment resulting in a $1,655 monthly student loan payment . This would quickly reduce the debt and would delay funding into a long term investment plan until these student loans are eliminated. After his car note is paid off in two years, he then will apply the $430 payment to the debt snowball to equal $2085/month applied towards the debt.

With these combination payments directed towards the debt, John is able to pay off his student loan balance in a little over 4 years. After his student loan has been paid off, he now has the cash flow to immediately start funding his long term plan into a tax deductible 401K. He plans to put the maximum contributions every year at $18,000. John also wants to contribute $430/month to short term and long term savings. Therefore, he is putting $215/month into a Roth IRA for long term tax free growth. He likes the flexibility of a Roth IRA to where he can take out his contributions penalty & tax free. He decides to put the other $215 to build up his emergency fund in a liquid savings account to cover short term expenses related to health care, truck maintenance, and vacations in the near future.

John is maxing out his 401(k) with no match and investing $2580/year into a Roth IRA low Cost mutual fund. John paid off his student loan debt in a little over 4 years. Ten years after paying off his student loan, he has accumulated $34,074 in his Roth IRA at a compounded rate of 5%. Inside his 401(k), over 10 years, he has accumulated $236,010 at the same interest rate.

John is satisfied with the growth of this investments, however, the accessibility of his money is absent in his 401(k) with the exception of the ability to borrow from the 401(k) plan and his liquid savings. He also knows that he can access the contributions to his Roth IRA without taxation or penalty. However, he loses that money when he takes it out and therefore John does not want to alter his growth trajectory from the Roth IRA. Nonetheless, having access to liquid capital is paramount to John in his financial landscape so he can take the money out to enhance his plan if other opportunities/investments come into play.

In year 20 he has accumulated $525,471 inside his 401(k) investment plan and has accrued $89,576 inside his Roth IRA mutual fund. Those investments continue to earn a 5% compounded rate including investment management fees. This is also assuming no down years and a continual compounded interest rate for 5% in both investment accounts. Disclaimer: We are assuming this rate due to the S&P 500 Index Growth with dividends since the year 2000 until the present.

John plans to retire from his current position at age 65. At Age 65, his Roth IRA has accumulated $179,983 at a compounded annual growth rates of 5% every year. The Roth IRA is a good tax free strategy because John believes tax rates will be higher in the future than they are now. The Roth calculation already assumes the fees into the growth.

Disclaimer: In both scenarios, even though this is highly unlikely, we are assuming that his income and contributions remain the same to create an non-biased scenario.

At that age John has stockpiled $910,721 inside his 401(k) and at a compounded annual growth rate of 5% every year. However, this does not take into account what tax rates will be and how that can affect his income in retirement. If tax rates were at a 25% rate and the account fees over the life of his 401(k) was 2.0% every year; his net estimated account value would configure to be $541,028 for account net usage. His net tax deferral over 30 years is $107,043.

However, the table below shows how fees and taxes are a detriment to the long term growth strategy with tax deferral inside this qualified plan. This table was used by a Truth Concepts qualified plan calculator. John paid off his debt in a little over 4 years with the debt snowball approach and also took advantage of some traditional planning vehicles. He will have an estimated net value of $541,028 in his 401(k) and an estimated $179,983 of tax free money for a total estimated asset calculation of $ 721,011by age 65 to utilize for his retirement goals. Therefore, let’s look at another method to help John pay off debt while saving money for long term goals at the same time.

Alternative Method in Paying Off Higher Interest Rate Debt

In this example we will use the same numbers, but we will allocate his money in a different fashion. This time John puts $1,000 into a private reserve account as a long term savings strategy and uses the debt snowball effect after he pays off his car note in two years. Compared to the IRA & 401(k) the private reserve account has liquidity to where he could access his cash versus tying it up. Therefore, by utilizing this approach John actually uses his private reserve account to save and pay off debt at the same time. The first method is a quicker method to pay off debt, but does not factor in opportunity costs. Opportunity costs are the benefits one could have received by taking a different approach. Therefore, instead of sinking capital solely into debt; what does money continue to earn if it doesn’t give up the opportunity to earn more interest over the long term. Money can either earn interest or give up interest. John chose to focus on earning more interest using this strategy.

This alternative method pays off his total debt in 9 years. That is the negative, but John never stops saving $1,000/month in the process. Therefore, the time value of money is exercised in saving first and then paying off the debt when the capital is there. When he finishes paying off the debt in 9 years he wants to devote another $870/month into the private reserve strategy and continues accumulating tax efficient liquid capital. In using the private reserve strategy he has paid off his traditional student loan balance in a little over 6 years with his private reserve account. He takes another 3 years at his own pace to pay off the debt owed inside his private reserve account. In order for him to do this he uses the debt snowball method after his truck is paid off & the private reserve strategy.

Time line of Debt/Savings Reallocation Plan

  • Month 20- At the end of the second year, while he is saving $1,000/month into the private reserve account, John directs $430 (his previous truck payment) on top of the student loan payment. Therefore, he is now directing $1085/month to the student loan.
  • Month 36- John is able to draw $22,406 from his private reserve account and directs that lump sum to push his debt down from $87,878.04 to approximately $65,472.96. At that time he can “recast” his debt payment down and ask the financial institution to issue a new amortized monthly payment with the new balance. Therefore, at 6.5% interest rate with 284 months remaining his new monthly payment will be $435.33, not $655/month. Therefore, he can take $222 and applies it towards the debt snowball plan. Now, he is applying $1307/month ($1085 + $222) towards his monthly installment of $435.33 and still saving $1,000 month.

Yr 1-$7,109

Yr 2-$14,632

Yr 3-$24,896

Yr 4-$38,201

Yr 5-$52,178

Yr 6-$66,850

Yr 7-$82,257

Yr 8-$98,416

Yr 9-$115,369

Yr10-$133,159

  • Example of the Growth in the first 10 Years

    In Month 75– He can direct $24,981.30 out of his private reserve account and pay off the student loan debt completely. Therefore, it took him 6 years and 3 months to pay off the student loan debt.

Lastly, he has to pay off the “line of credit” that he used from his private reserve account. He has to pay that back just like he would a typical line of credit. However, this line of credit is more flexible than a traditional line of credit.

This borrowing strategy is structured privately and does not affect his credit, nor does it report to credit bureaus. John can pay it immediately when he takes the money out or can wait a period of time and pay it back on his terms. He is acting just like a bank acts, excepts he makes the terms. Therefore, he owes $48,000 back to the private reserve account’s company. He decides to pay the debt immediately and plans to spend an amount similar to what he was using for the debt snowball approach.

Therefore, at an interest rate of 4.5% his payments will be $1325 for 40 months. Therefore, in 115 months (9 years and 7 months) he is free of obligation in regards to his student loans.

***This approach is less conventional, but in comparison with any savings/debt reduction plan this approach (garnering certain circumstances {loan balance, interest rate, and time})is extremely efficient.***

****John was able to have more capital saved in the long run by effectively starting a system of savings as opposed to putting all of his capital at his student loan balance and never seeing those dollars again. John was able to efficiently pay off his debt, while measuring his “opportunity costs” in his long term financial plan. Using the first method John would have used a minimum of $50,000 into sinking his student loan debt. Therefore, (using a future value calculator ) if that $50,000 would have continued to compound over 30 years at 4% he would have had an additional $162,170.

Therefore, if one utilizes the first method this turns out to be an expensive financial mistake.

John was able to have more money saved in the long run and paid off his debt in a more efficient manner. Therefore, John started saving $1,000 month into a Private Reserve Account backed by a mutual insurance company. When he paid off the debt in 9 years he wanted to put $870/month into another plan while putting the remainder of his liquid capital ($230/month) into a liquid bank account. At age 65, when John plans to retire he has around $1,007,885 from his first plan and another $516,888 from his second account opened at age 39.

At age 50, John plans to take $300,000 from his private reserve account and purchase a small apartment building. He plans to get around $6,000/month in rent with his expenses (mortgage payment, insurance, maintenance, and taxes) totaling around $3,000/month. This creates a passive net income of $3,000/month for John Since, his money is not mainly tied up in a qualified plan he has the opportunity to look for “wealth building” opportunities.

His private reserve account has grown to $1,524,773 at age 65. He stops funding it at age 65, but the cash will continue to grow due to the ever increasing compounding interest.

He shares in the profits because he is an owner of the mutual insurance company and therefore his value of profits, or dividends, is at an estimated $385,000 at age 65. The funds he has accumulated in his cash value will all be dispersed to him in retirement tax free. Therefore, from age 65 to age 90 he will receive $93,596.05 tax free every year along with an additional $3,000 month of passive income from his apartment building. If he lives to age 105 he can still take around $88,198 tax free and still has a balance of over $500,000 left over. Therefore, running out of money is not a concern for him. Overall, he put in $678,401 into those two private reserve accounts and he is getting back $2,339,901 tax free until age 90. If he lives until 105, he will receive approximately $3,527,920 back tax free because his account has an ever increasing compounding effect. This is not factoring in his rental income.

Let’s compare the two methods in the table below.

New Way to Look at Reduction Traditional Debt Method & Savings Methods Years to Pay off 4.5 (This one wins!) Non-Traditional Debt Method & Savings Approach 9 years and 7 months. Benefits of Savings Methods 401(k)- Save up to $18,000 per year, tax deductible, competitive rate of return Roth IRA- Private Reserve Account- Liquidity, Use, Control, competitive rate of return, Disadvantages of these Methods Tax Free Growth and Distribution along with flexibility with your contributions.

Your Money is not widely accessible in the 401(k) and IRA and you are capped by the government in saving in a tax free vehicle based on your income and contribution limits. Your funds experience volatility and there is no guarantee protection from creditors, tax efficient, death benefit, & total safety with no volatility.

It took 9 years to effectively pay off debt versus 4; Your cash growth in the initial years isn’t as much compared to an IRA/401(k), but the power of compounding interest over time is the difference for future performance.

$721,011
$1,524,773

Account Growth at age 65 along with dividends available equal to an additional liquid $385,153; not including his rental income.

When it comes to looking at debt, always examine the savings rate you can earn versus the interest rate you are giving up. This is not a one size fit all type of strategy, but it can and will work more efficiently than the traditional debt snowball method once analyzed properly.

Conclusion: In order for consumers to climb out of the slavery of high interest rate student loan debt, there needs to be a paradigm shift in thinking. While the debt snowball strategy is a good way to get out of debt, it is not a long term efficient plan for debt reduction & building tax free liquid capital. Instead of thinking how we are going to get from point A to point B in regards to getting out of debt, let us think differently with the value of uninterrupted compounding interest & having our money work for us in more than one way. We are either paying interest to a lending institution or giving up interest on what we could have earned when we sink our hard earned capital into a negative interest bearing account.

One needs to factor in Opportunity costs! Let us hasten away from the enslavery of traditional lending institutions and create opportunity with our own personal economic systems. I hope this case study provides great insight into how we need to start becoming asset managers instead of debt managers and in turn will truly lead us into a greater degree of financial freedom.

Note: All debt calculations were used by a debt snowball calculator, debt reduction calculator, a loan analysis calculator, and a borrowing strategy calculator. All financial calculations for the qualified plan and Roth IRA were used by a cash flow calculator and a qualified plan calculator. The private reserve account was used by a mutual company’s life insurance software to calculate net returns.

Published and completed by June 2015

This publication is designed to provide an accurate depiction of a real case study on debt reduction with student loans. The intent of the information is purely educational and informational. If legal, accounting, or tax services are required, the services of an independent tax or legal counsel should be sought after. Study Research and Publication by Sam Denton, Owner of Denton Wealth Strategies in Baton Rouge, LA.