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Base your debt burden on your expected earnings

  • Article by: CHRIS FARRELL
  • February 26, 2011 - 9:07 PM

Q In May of 2012 I will graduate from law school with about $85,000 dollars in debt. I have about $55,000 in stocks and mutual funds. So far my strategy has been to take loans assuming I would earn more on the investments than I would pay in interest on the loans. I'm wondering if I should I cash out my investments now and pay down the debt. Is there a rule of thumb to know which strategy to take?

IAN

A You're in a good financial position whatever strategy you decide on. Still, a reasonable rule of thumb is not to borrow more than you expect to earn with your starting salary. It's a guideline for keeping the debt burden manageable. Fact is, you really can't go wrong by simply limiting how much you borrow.

But here's a suggestion. My guess is that by the end of your second year in law school and following your summer internship you'll have a pretty good idea what you'll be doing as a lawyer when you graduate. In other words, you'll be able to judge within a reasonable range what kind of income you might command, say, if you go to work for a private law firm, join the legal department at a major corporation, take a job at a nonprofit organization or accept a government job. You'll then know whether $85,000 is an onerous or easily manageable debt burden. If the debt burden is onerous, get rid of it.

Now, let's add one more layer to the issue. You will have a good sense about your annual income and you also may know how steady that income might be. When young adults enter the job market they're mostly "human capital." They have their knowledge and their education (human capital) and own little in financial assets. But you have an edge here with $55,000 in savings.

Human capital is much like a bond for young people who end up in a relatively stable job. If your income is reliable you can afford to carry more debt and put more money into equities. With this scenario you'd probably be fine sticking with your investment portfolio.

Yet now let's assume your career has greater income risks. Maybe you'll take a job with a low base salary, but plenty of opportunity for bonuses (or not). Perhaps you'll put out your own shingle -- a lawyer as entrepreneur. In either case, a good portfolio would be more conservative. I'd get rid of the debt to offset the risk inherent in your job choice.

A good investment rule of thumb is to stick with cash and steer clear of stocks if the bill is due in five years or less. The reason is that the stock market is simply too volatile over such a short period of time. You don't have to get out of stocks altogether, but you might want to consider taking some equity gains during stock market rallies and add to your cash pile.

Chris Farrell is economics editor for "Marketplace Money." Send questions to cfarrell@mpr.org.

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