How to Decide Between Paying Off Student Loans Early Or Investing (Or Both)
The following is a guest blog post:
By Laur Davidson, personal finance journalist
From early on, we are all told that non-mortgage debt is bad, and that we should do everything we can to become debt-free if we ever expect to be financially independent. However, we are also told that, the only way to build sufficient capital for a secure retirement is to save early and save often. So, student borrowers about to embark on a new career, which should it be?
The answer may not surprise you: It depends. Obviously, each individual’s circumstances are unique and there are many factors to consider including, the rate of interest, the returns on investment, the rate of inflation, your tax rate, your attitude about debt, your attitude about risk, and your ability to stick to a disciplined, long-term investment strategy. So, you will need to explore all of the factors and assumptions that go into determining which strategy is best for you.
The Case for Accelerated Debt Repayment
Your Attitude about Debt
Nobody likes debt, and we are constantly admonished to get out or stay out of debt. And, when you’re finally debt-free, there’s no better feeling. No debt payments mean more cash flow for savings or lifestyle upgrades or an earlier retirement. The case for prioritizing debt repayment over savings can be made based purely on emotional factors alone.
High Interest Rates
Unless you know of some guaranteed investment that can earn 25 percent per year while you pay 21 percent on your credit card (it doesn’t exist), there’s simply no rationale for not paying off your high interest credit card. When you make a $100 payment on a credit card with a 21 percent interest rate, it’s the equivalent of earning a 21 percent rate of return, or $21. Pro tip: Check out this investment return calculator from Bankrate to run and compare costs/savings!
Interest Cost Savings
Perhaps the biggest reason to pay down debt quickly is the savings in interest costs. By paying student loan debt as quickly as possible the savings in interest costs can be plowed into savings allowing you to play catch up. Pro tip: You may also look into refinancing opportunities to lower your interest rate and increase your savings. Just be sure to research the pros and cons first to make sure refinancing is right for you.
The Case for Investing
The High Cost of Waiting
What most people fail to grasp is that time is a very valuable asset, but it is also a wasting asset. To put into perspective the true time value of money, consider two young adults who begin their careers at age 30. The first, Janice, begins to invest $30,000 per year at age 30 and, after 15 years, stops investing at age 45. Frank puts off investing until age 45, and then begins to invest $30,000 per year for 20 years – five more years than Janice – until age 65. Assuming they both earn an average return of 6 percent, at age 65, Janice would have $2.3 million, whereas Frank would have just $1.1 million.
The point is clear, the cost of waiting can be prohibitively expensive. The longer you wait the more it will cost you to reach your goal, or you will need to take greater risks. Conversely, the more time you have, the more opportunity you have to build wealth.
Missing out on compounding returns is one thing, but you should never walk away from free money, especially when it can increase your compounding returns. That’s essentially what you get when you contribute to your employer’s qualified retirement plan if it offers a matching contribution.
Currently, you can contribute up to $18,000 in a 401(k) plan. The first benefit you receive is an immediate reduction in taxes because your contribution, which comes from your salary, is made before you have to pay taxes on it (see examples of other common tax deductions here). The second benefit you receive is a matching contribution from your employer (not all employers offer matching contributions), which is like getting an instant, guaranteed return on your money. The matching formula varies from one employer to the next but a typical match is 50 percent of your contribution for the first 6 percent of your salary – the equivalent of 3 percent of your salary.
No one wants to pay unnecessary interest on debt, but, it could be just as financially harmful to miss out on the time value of money, tax breaks, and years of compounding returns. And, with so many factors to consider and so many variables within individual circumstances, there can be no single solution that can be applied to everyone. A strong case can be made for either strategy; however, the true determinants are individual attitudes, goals and circumstances. In addition, we can’t predict the future, so we can’t say how our individual circumstances might change, nor can we forecast economic conditions. So, an either/or approach to determining which route to take may not be realistic; rather, a blended approach that incorporates the strongest elements of each may be the most prudent.