Tuesday, August 23, 2011

Paying cash for my MBA makes financial sense

I wanted to take a post to get back to the basics of my goal of graduating debt free.  I feel like the core message of financial benefit has been lost amid all of the lifestyle issues and deviation from the norm.  I figured doing a straight financial discussion of foregoing student loans to pay for my MBA would be a good follow up to the post about debt in general.  To some extent the analysis presented in that post is the analysis I went through when deciding to try to pay for my MBA in cash, on top of non financial issues.

When deciding to avoid student loans when getting my MBA I wanted to minimize the negative impact that paying for an MBA would have on my finances.  Sure there's a big potential upside to an MBA but it comes at a cost and I wanted to minimize that cost.   I had a fair amount of cash in hand earning piddly rates and after financial aid and some personal budget cuts I could project a chance at needing no debt at all.  In general, paying cash is always cheaper than paying with some sort of financing with the only caveat being interest and fee-free loans and opportunitiy cost.

Fundamentally, what I’m saying by paying cash is that the cost of debt for business school is higher than the risk-adjusted rate of return I expect on my investments/cash over the next few years.  The risk-free rate is historically low right now while student loan rates are not.  Even subsidized Stafford loans still have a 1% disbursement fee and they’re going the way of the dodo for grad students next year.  I might be able to take that money and generate around $150 at best in profits through a CD but then that return is taxed and there is a risk of a paperwork snafu or fee that would eat a lot of the return.  The gain from a CD seemed minimal enough to be foregone and potential downside from losing money in the stock market or other investments too high.

The interest rates on non-subsidized loans right now are 6.9% or 7.8% for Federal loans and the lowest I’ve seen for private loans is 6.25%.  All of these have disbursement fees, typically 1-4%. I can’t guarantee that my investments can beat that, particularly after taxes and fees for both the loans and the trades, and my personal preference is to discount returns heavily with risk so the off chance of beating the market and returning 30% on my investments isn’t appealing to me.  Therefore, the best financial decision I can make is to pay for my MBA in cash.  After I potentially run out of cash it still doesn’t make sense to take out student loans at 6%+ APR, instead I’d liquidate some of my investments in my Roth IRA since I can access without penalty and, again, can’t find a risk-adjusted rate of return that turns an after taxes and fees profit that beats the cost of the student loans.

Drawing down a traditional IRA over taking out student loans would also make sense since these funds can be used penalty-free for educational expenses.  Plus, while in school you won’t be earning a full-time income so your tax rate on the IRA funds is likely to be fairly low.  You have to pay taxes on it as some point so the question becomes if you think your tax rate will be substantially enough lower in retirement that the cost of cashing your IRA is higher than the cost of student loans.  This is highly unlikely.   The only scenario where debt would be cheaper would be in comparison to 401k money.   However, most students will leave their employers when coming to business school leaving them free to roll the balance of the 401k into a rollover IRA which then allows distributions for education expenses without penalty.  I don't anticipate needing to do this (at this point I have hope of not even touching the Roth IRA), but do know that it would be my next step if my Roth IRA is exhausted. 

Bottom line is that by using cash to pay for my MBA I’m minimizing my cost of capital and opportunity cost, making the overall cost of paying for my degree cheaper, and increasing my potential return on investment. Minimizing debt just makes good financial sense.

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1 comment:

  1. "Minimizing debt just makes good financial sense." Absolutely. I'm battling my own law school loans right now and I have a plan to repay it in 3 years. I didn't have the option of not taking out a loan. I think too many students are unaware of how difficult it really is to pay off student loans.