This article was co-written by Sierra Johnsrud.
If you are a recent graduate lucky enough to land a well-paying job upon graduation, you may now face a common dilemma: “Do I begin saving for my future, or do I pay off my student debt now?”
The answer depends on a large number of factors. Every person has different financial goals and risk tolerances, as well as different beliefs and feelings around debt. The amount of your debt and what interest rate(s) you’re paying are also crucial factors.
In order to make an informed decision about where to put your money and to come up with a plan you can feel good about, it’s essential to assess your complete financial picture. Here are helpful guidelines you can use to prioritize your thinking about this decision.
What are your liquidity needs?
Should you pay off student loans or save for emergency fund use?
In this case, emergency funds take priority. It’s extremely important to have enough liquid assets to meet your short-term expenses should the need arise. The rule of thumb is to save 3-6 months of expenses (including student loan payments, regardless of whether your loans are in deferment) in cash as an emergency fund.
Whether you save three months or six depends on your anticipated short-term cash needs, your feelings about your job security and your family situation. Your emergency fund can help you cover 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 too much of 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.
Do you have an employer match?
Should you pay off student loans or save for retirement?
It depends. If you have an employer-sponsored retirement plan such as a 401(k) or 403(b), 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 — and prioritize doing so 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.
Your 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, you can 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’s 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 long-term on your investments, then you are losing out on a 3% return each year by paying off loans instead of investing.
Risk-driven vs. risk-free returns
We all know that investing involves taking risks. 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).
If you have student loans that carry a 6% interest rate, your money used to pay down extra principal will earn you that 6% over the term of the loan, regardless of any external economic and market factors. An investment account, on the other hand, can be significantly more volatile.
Yes, you may be able to realistically expect that in the long run, your investments will earn more than 6%, 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 may make sense to prioritize extra payments toward your student loans if your interest rate is close to your expected investment rate of return. However, the power of compound interest is also an important factor of investments, so it may be most beneficial to leverage a combination of paying off student debt and retirement savings, especially if you have an employer match as mentioned above.
Are you pursuing a student loan forgiveness program?
If you’re aiming for Public Service Loan Forgiveness (PSLF) or Income Driven Repayment Forgiveness (IDRF), you should not make additional student loan payments. Because making extra payments will mess up your future qualifying monthly payments, you could instead consider investing the amount you wanted to pay into a brokerage account. This is especially helpful if you’re worried the rules around these forgiveness programs may change in the future — investing extra funds into a brokerage account is a good way to save and access the funds you may need if forgiveness for some reason doesn’t work out.
Saving for large purchases
Should you pay off student loans or save for house payments?
Making financial decisions can be difficult because you typically have many goals in mind — and they can be conflicting in nature. Where does saving for a house fit into paying off student debt or contributing to your 401(k)?
In an ideal situation, you will have saved 20% of the home value for a down payment, which is no small amount.
If you consider this from a strictly financial standpoint, it makes more sense to use your excess cash to invest for retirement over saving for a house based on the assumed investment returns. The stock market on average has far outperformed real estate on a long-term basis. In addition, the younger you start contributing to a 401(k), the longer time you have for compounding interest.
From an emotional standpoint, however, we understand that most people don’t consider their home as an investment. It’s more so a place to start a family or begin to settle down.
Your savings strategy will depend on your time frame for purchasing a house. If you are looking to buy in the next couple years, you may have to forego some of your 401(k) contributions or additional student loan payments to reach the down payment amount you need. If you are looking to buy within 5-10 years, you may be able to manage saving for both a house and retirement, as well as paying additional amounts toward student loans.
Do what feels right
In the end, you should come up with a plan that suits your financial goals and comfort with debt. After considering 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 you are more comfortable carrying debt and/or your interest rate(s) are fairly low, then it may make sense for you to start prioritizing investing now. On the other hand, if your interest rate(s) are relatively high and you are uncomfortable with carrying debt, then prioritizing paying down your debt more than what you put towards investments is probably your best option.
Keep in mind that you are not locked into doing one or the other. For some, a mix of paying down a little extra principal on debt while also investing some for retirement or saving for a home is a strategy that works well.
If you need assistance determining the best plan for your situation, Wipfli Financial can help. We take a look at your full financial picture, walk you through different strategies and help you give life to your financial goals.
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