If you are a recent graduate who was lucky enough to land a well-paying job upon graduation, you may now face a dilemma: “do I begin saving for my future, or do I pay off my student debt now?” Of course, you must be sure to avoid missing payments on your student loans and, at the very least, meet your monthly minimums. Some of your peers may not have an option if they can only afford to make those minimum payments.
But if you have income in excess of your monthly expenses — including your minimum payment(s) — what is the best way to put that money to work?
The answer depends on a large number of factors. Each individual will have different beliefs and feelings regarding debt, risk tolerance, and financial goals. The amount of your debt and your interest rate(s) are also crucial factors. It is essential to assess your complete financial picture in order to make an informed decision about where to put your money and come up with a plan that you can feel good about. That said, there are a number of guidelines to help prioritize your thinking about this decision.
You’ve probably heard the saying, cash is king. While those who understand the power of inflation will take exception to this cliché, it is extremely important to have enough liquid assets to meet your short-term expenses should the need arise. It is a good rule of thumb to have 3-6 months of expenses put away in cash as an emergency fund. This number can be more or less, depending on your anticipated short-term cash needs, feelings about your job security, and family situation. This emergency fund can help you to cover those unpleasant surprise expenses (car repairs or medical bills, anyone?) as well as meet living expenses should you suddenly find yourself out of work. The last thing you want to do is spend your excess income paying down more of your 6% interest student debt, only to find yourself having to take on 23% interest credit card debt to make ends meet.
Employer Match Opportunities
If you have a 401(k) plan, does your employer offer to match your contributions? If so, you should seriously consider contributing to your 401(k) up to the amount that your employer would match before accelerating the repayment of your student loans. If you look at contributing to your 401(k) in order to get an employer match as an “investment,” it’s just about as good of an investment as you could ever hope to make. You are essentially getting an instant 100% return on your contribution, or doubling your money, with absolutely no risk! Of course, if the funds in your 401(k) are invested, you will be taking on investment risk after the contribution and match go into the account, but that doesn’t change the fact that this strategy is a great option. One thing to note is that if your employer has a vesting schedule for their matching contributions, and you feel like you may leave your employer in the next few years (before those contributions are fully vested), then this option may not be as attractive.
Loan Interest Rate vs. Expected Investment Returns
One of the most critical factors in determining whether to pay off your student debt or begin saving for retirement is the interest rate on your loan(s). Just like the 401(k) contributions above, it is useful to view your loan payments as an “investment.” In the case of your student debt, the annual return on “investing” your money in extra principal payments is equal to the annual interest rate on your loans. The higher the interest rate, the greater incentive you have to pay down your loans over other options. It is also important to consider the spread between the annual interest rate on your debt and the annual return you would expect to receive by investing your money for retirement. If your interest rate on your loans is 4%, and you expect that you could make 7% per year on your investments, then you are losing out on a 3% return each year.
In addition, you may be able to deduct some or all of your student loan interest on your income tax return, which would effectively widen this spread slightly, and make it even more favorable to start investing.
Take a hypothetical graduate, John, for example. John has $40,000 in student debt, a 4% interest rate on his loans, a 10-year loan term, and $750 per month in excess income, before his minimum loan payment. By using the full $750 per month to pay off his loan, John is able to cut the repayment time from 10 years down to just under 5 years. However, as demonstrated in the chart below, John would lose out on almost $39,000 after 40 years (assuming a 7% investment return) by not using the surplus to invest for retirement during those first 5 years.
Unfortunately, this hypothetical interest rate of 4% is likely far too low. Many students who have recently graduated carry student debt with interest rates upwards of 6%. As the interest rate on your student debt converges with your expected investment return, the value added by investing while you pay off your loans goes to zero. Certainly, if you expect that your investments will have an annual return that is less than the interest rates on your loan(s), it makes no sense to start saving now. Still, as long as your expected investment rate of return is higher than the interest you are paying on your loans, you should start investing to capture that spread, right? Not necessarily. There is an enormous difference between the expected rate of return on your investments and the “return” you get from paying down debt.
Risk-Driven vs. Risk-Free Returns
Say you have a number of student loans with an average interest rate of 6%.
Now, imagine for a minute that you have no debt at all and want to begin saving for retirement. Would you feel comfortable borrowing money at 6% interest and investing it? Even if you believe you can earn 7% on your investments? How about 8%? This is exactly the type of question you need to ask yourself before deciding to save for retirement instead of paying down your loans. When we say “save” for retirement, what we really mean is invest for retirement. It makes no sense to forego paying down your loan principal to put money into a savings account (unless, of course, you need liquidity, as discussed above).
We all know that investing involves taking risks. All conventional investment returns are functions of risk. That is, the more risk you take, the more return you should expect to receive as compensation. On the other hand, paying down your student debt nets you a “return” equal to your annual interest rate, and it does so without taking any risk at all (we will disregard floating-rate loans for the purposes of this discussion, which do involve some degree of interest rate risk). Again, if you have student loans that carry a 6% interest rate, your money that goes to pay down extra principal will earn you that 6% every year, regardless of any external economic and market factors. An investment account, on the other hand, can be significantly more volatile. Yes, you may expect that in the long run, your investments will earn 7-8%, but you certainly won’t experience returns in that range every year. Your investments may lose 10% in a given year and then gain 15% the next. This means that your decision to invest could look very poor in the short term if you happen to invest before a market downturn.
All that considered, it makes little sense for you to start investing for retirement before you pay off your student debt, particularly if your interest rate is anywhere close to your expected return on investment. Again, ask yourself a hypothetical question: “Would I rather have a guaranteed 6% return, or a 7-8% return with a chance that I may lose money?”
Do What Feels Right
In the end, you must come up with a plan that suits your attitudes about debt and your financial goals. After considering things like your emergency fund, upcoming expenses, and 401(k) match program, you can then make an educated decision about the best use of your excess income. If saving for retirement is extremely important to you, you don’t mind carrying debt, and/or your interest rate(s) are fairly low, then it may make sense for you to start investing now. On the other hand, if your interest rate(s) are relatively high, you are uncomfortable with carrying debt, and/or you are fairly conservative when it comes to investing, then paying down your debt first is probably your best option.
Also keep in mind that you are not locked into doing one or the other. You may find that a mix of paying down a little extra principal on your debt while also investing a smaller amount for retirement works best for you.