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Guest Post

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.

 

Free Money

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.

 

Conclusion

 

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.

 

10 Comments

  1. This was a great post and definitely relevant to my current situation. I have two remaining student loans. One is at 6% interest rate and the other at 2.25%. I decided to try to pay off the higher interest rate as soon as possible. The reason being is that although my monthly payment on that student loan is $0.00 and I won’t have a payment due until 2020, when the payment becomes due, it would be $1174 per month. Ouch. Thankfully, I was able to bring that student loan down to $2600 (after my last payment of $1500).

    Like your post suggests, I think I might take a blended approach to paying off my student loans. The higher-interest student loan will be paid off by July (crossing fingers). However, the lower-interest student loan has a balance of $20,000. I thus have a very big decision to make, come July. Do I try to pay off that student loan, which would probably take me slightly less than two years? Or, do I concentrate on investing. That’s a very low interest rate (2.25%) and the monthly payment is only $97 (which I believe is fixed – although I need to double check that).

    Decisions, decisions. I don’t want to make this comment too long. I just wanted to say thank you for the post. Although I’m still undecided, the various factors you laid out are the very same ones I have to think about with regards to my decision on paying off that last remaining student loan or investing.

    1. Yeah everyone’s situation is different. Looks like you are taking the same approach as I did when I was paying down my student loans. I choose the higher interest loans to pay back first to cut down on the interest. Lowers the monthly payment total for you as well once it is fully paid off. Guess there is no wrong way to go about it. Just depends on the person. Some people, myself included, hate debt so would try to burn it down as fast as possible. Others say that interest rate is super low and can make a higher yield with investing. So more time in the market = higher returns long term. Or you could do a blended approach. Pay slightly more each month to hit principal but also keep putting a little into your portfolio. Good luck with your decisions and thanks for the comment.

  2. I think it’s a better idea to pay off debt first. If you’re just getting started in the markets, don’t expect to shoot the lights out.If the economy tumbles into a recession, you will lose a lot of money on your investments and you might lose your job! In that case, there’s no way you’ll pay back your debt.

    1. That is one thing about the market, we can never predict it. Personally, I hate debt so I would lean toward paying any off that I had. The “extra” money I have then would go into the market. But everyone is different so they have to gear it toward their situation and goals. Thanks for your comment.

  3. This is the really great thing about personal finance. Everyone knows the math at the end of the day but it’s what people feel most comfortable with. I know on paper it made more sense for me to invest in the stock market but I hated my mortgage. So I paid it off and it makes me feel so much better not having the anchor of debt weighing around my neck. But for others they love to leverage debt to build wealth. So whatever makes sense for you is what I normally tell people 🙂

    1. I like the way you think. There is a psychological aspect as well that we don’t see. So you have to factor in your own thoughts and feelings about a subject before making an informed decision. Escaping from the stress of debt can be as good as a ROI. Thank you for your comment.

  4. Depending on your view, I think debt can be a great tool to help you build wealth. I don’t fear debt nor interest payment as I use debt to purchase income generating assets and use interest payments as a form of tax strategy to lower my income taxes.

    Debt, when used responsibly, I can be a great asset.

    1. I agree with you there. Debt can be a great tool but it is a scary subject for most. We can see by your portfolio how you used it to your advantage very well. Just need to educate yourself beforehand and have a strategy in place. Also, it depends on what risk tolerance/ fear level you have toward debt. As always, I appreciate your comment.

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