These days, holding a college diploma is table stakes to qualify for a decent job. Because more people than ever attend a four-year college and that degree is the minimum qualification for many positions, we’ve also seen a spike in students who continue their education to pursue a graduate degree.
But with more school comes more student loans. Once you finally finish all your schooling and start earning a full-time income, you need to decide if you should pay off your student loans as fast as possible or contribute available cash flow to investments for long-term growth.
The right answer for you depends on a variety of factors, but the optimal solution might be a little of both. Although being debt-free is appealing to many people, don’t underestimate the benefits of investing early in life.
Why It’s Important to Invest as Early as Possible
For simplicity, let’s imagine two college graduates with access to a tax-deferred investment account earning 8% per year. The first investor saves $250 a month for ten years (for a total of $30,000), and then never makes another investment for the next 30 years. At the end of the 40-year period, their portfolio would have grown to $509,605.
The second investor, on the other hand, does not invest at all for the first ten years of the same 40-year period. Instead, they contribute $250 a month to investments for the next 30 years for a total contribution of $90,000.
Who do you think has more money in their portfolio at the end of 40 years? You might say the second investor, who, even though they waited to start, made more total contributions than the first. But the second investor would only have $375,074 in their portfolio.
Despite saving more money over a longer period of time, the investor that started later ended up with $134,531 less. Time and the power of compounding is the most potent combination for wealth creation.
Of course, there is a flip side to consider. Yes, the benefits of compounding investments are enormous – particularly if you have multiple decades until retirement and are utilizing tax-deferred accounts – but student loans with interest rates exceeding the expected returns on your investments probably deserve more of your extra savings.
How to Prioritize Investing While Paying Off Student Debt
Optimizing the amount of you use to invest versus pay down debt depends on the interest rate, term, and payment features of the loans. The optimal choice for you also depends on the savings vehicles available and the expected return on the investments you make into them.
Evaluating these variables can help you arrive at the optimal solution from a purely mathematical perspective.
However, the decision is based as much on your personality as it is the math – after all, we don’t live in a spreadsheet.
Some people prefer the idea of being debt-free. Others will prefer to optimize the return of their savings. Perhaps you might like the idea of doing a little bit of both.
With that in mind, here is my personal preference on how to prioritize paying down student debt versus investing.
1. Contribute to your employer sponsored retirement plan up to the match.
It’s hard to find a guaranteed 100% return on your investment, but an employer match on your retirement plan does just that. If your employer offers a match on some portion of your 401(k) (or 403(b) or 457 plan) contributions, invest at least that much. Otherwise, you leave free money on the table.
For example, if your employer has a 3% match and your salary is $100,000 a year, contributing at least $3,000 of your own money entitles you to the full matching contribution. Once you invest at least enough in your employer plan to receive the match, move on to the next account.
The sooner you begin investing, the more time you’ll have to leverage the power of compounding and likely the more money you will accumulate. Even better, since you’re investing in a tax-deferred account, you enjoy additional tax benefits too.
2. Create an emergency fund.
You can’t ignore the importance of having some money available for unexpected expenses, regardless of whether or not you have debt. In fact, allocating some portion of your excess savings to an emergency fund takes priority over any extra debt repayment or additional investing.
Depending on your situation, an emergency fund ought to have three to 12 months of expenses within it. That may sound like a lot of money, but this cash account doesn’t need to be built overnight. If your emergency fund is starting from zero, then allocate at least 10% of your excess savings each month to an emergency fund. If you have a high degree of job security and income predictability, then you can probably build this account up more slowly.
Online banks tend to pay the highest interest rates these days. Plus, keeping your emergency savings in an online bank separate from your primary checking can help you avoid the temptation to access those funds for non-emergencies.
3. Pay down private loans with the highest interest rates and least payment features.
If your interest rate is above 8%, then it probably makes sense to allocate your remaining savings towards extra principal payments on these costly loans. If your interest rate is between 6% and 8%, then perhaps allocating half of your excess monthly savings is enough before investing more.
At this stage, you want to hold off on prepaying your federal student loans. Private student loans typically charge a higher interest rate than federal student loans. The also tend to offer less payment features commonly found with federal student loans.
These benefits include payment and interest deferments while in school or returning to school, loan forgiveness for certain professions or public service work, income-based repayment plans, balance forgiveness at death, and situational loan payment forbearance.
Private student loans sometimes have a few of these features, but it’s rare they have all of them. The lack of payment flexibility and features also makes private loans a better candidate for consolidation and refinancing. (Federal student loans often lose their payment features when consolidated.)
4. Make the maximum contribution to your employer sponsored retirement plan.
Employer-sponsored retirement plans are often the cheapest place to access a diversified set of investments for retirement. Employer sponsored retirement plans such as a 401(k) plan offer tax-deferred compound growth, so it’s worth taking advantage of this benefit to reduce your tax burden.
Your plan may allow you to make contributions to a Roth or Traditional account. If you expect to be in a higher tax bracket during retirement than the one you’re in today, the Roth 401(k) is the superior option. If you expect to be in a lower tax bracket during retirement than you are today, a Traditional 401(k) probably makes more sense.
If you aren’t comfortable projecting whether your taxes will be higher or lower at retirement, consider making contributions to both the Traditional and Roth options. This strategy is known as tax diversification.
Employees of nonprofit entities with access to a 403(b) should aim to max out that vehicle at this stage. The same goes for government employees with access to a 457 plan. Smaller employers sometimes provide Simple IRAs or a simplified employee pension (SEP) IRA option, both of which fall into this retirement savings prioritization category, too.
5. Pay off federal student loans with interest rates greater than 6%.
After maxing out your contributions to your employer-sponsored retirement account, then you can knock out your federal student loans charging at least 6% interest.
If you have a federal student loan with an interest rate below 6%, then simply make the minimum payments until the debt is repaid and allocate any excess cash flow to your other goals like investing for the future, building your emergency fund, or perhaps even buying a home. Lower interest rate federal student loans are not restrictively costly, especially when compared to the potential return in the stock market.
There’s one exception to this rule: if you work in a profession where your loans will be forgiven after a certain number of years, just make sure to follow the rules of the program to ensure your balances will be forgiven.
Should You Invest for Retirement or Paying Off Your Student Loans?
The above order of prioritizing savings largely ignores common emotions people feel with debt, but again, humans don’t live in spreadsheets. The psychological draw from being debt-free is hard for many to ignore.
It’s common for people with a relatively small amount of student loans to prioritize paying down that debt just to free themselves mentally from the obligation.
Others may prepay a loan more aggressively if they suddenly come into the financial resources to do so, and they want one less thing on their plate.
Some also feel a greater sense of control over their finances by being debt free. This is particularly true when a large debt is financially limiting. Paying it off early creates more control of their finances and optionality for their futures.
While there is no perfect answer, it’s important to remember the choice between paying down student debt or investing for the future doesn’t have to be a mutually exclusive decision. A mix of both is probably going to be the mathematically and emotionally optimal solution.
Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.