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Ask Money

Invest and borrow?

Chris Farrell Dec 10, 2008

Question: Hello, I love the show. I’m a bit of a personal finance geek and I look forward to it every week. I’m 25 years old and I’m returning to school in May for a year long program. Since I left college I’ve been making maximum contributions to a ROTH IRA (biweekly). I’d like to stockpile some additional money to help minimize the loans I need to help pay for school, so I’m thinking maybe I should stop my IRA contributions. However, I hate the idea of stopping contributions right now, when all the stock prices are so low and right after I’ve just lost quite a bit of money in the downturn.

So my question is: how do I prioritize this? Is it more important to minimize debt, or to continue to contribute to the IRA until I stop working to maximize my retirement money? Also, if it makes a difference I’ll be entering the health-care field so I don’t anticipate any problems finding employment after graduation. I’d appreciate any input on this dilemma. Thanks for your time, Peter, Buffalo, NY

Answer: We’ve been getting variations of this question from people wondering about how to think through the trade-off between debt and saving. For many people, the answer is don’t take on debt–especially in light of the terrible economy. It’s the right starting point for maintaining your financial freedom and flexibility when you graduate. Still, here’s a way to think through more carefully the trade-off you’re facing.

First, come up with some realistic numbers. What will be the full cost of school and how much would you have to borrow if you fund the Roth IRA? What will be your budget while in school? What will be your monthly debt burden when you graduate–and for how long? How much can you expect to earn when you graduate, and what kind of pay hikes or raises are common in your chosen career? I realize that the job market is tough right now, but you’ll still need to research this part of the equation. (The health care market has held up well during the recession, but there’s always a risk that jobs will be less plentiful when you graduate.)

Of course, you could make this even more complicated by making some assumptions about rates of return on investment. For instance, a recent paper by Christopher Carroll, professor of economics at Johns Hopkins University delves into the work of the legendary investor Benjamin Graham, as well as more current work by economists John Campbell and Robert Shiller, to judge stock market values over the next 12 years. He make a good case for assuming a 6% average annual rate of return on equities (net of inflation).

But you can’t control return. What you can control is the amount of risk you take. That’s why I would stay in the world of budgets, salary, and borrowing.

With these figures you can start playing with different scenarios. For instance, let’s say starting salaries are low and your debt burden will be high. (That would raise a question in my mind whether the degree is worth it, by the way.) In that case, I wouldn’t fund the Roth but focus on limiting your borrowing. However, if starting salaries are good, and the debt after graduation won’t eat up much of your income (perhaps you’ll be able to pay way more than the standard repayment schedule) then the case for funding the Roth is more persuasive.

Of course, the answer could lie somewhere in between the extremes–fund the Roth, but less than the maximum, and borrow less to pay for school.

The bottom line: Manage and limit your risk. Reduce the downside and weigh the odds. And then decide which trade-off you’re more comfortable living with. . .

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