So you’ve worked hard to cut out unnecessary expenses from your life, and you’ve suddenly found yourself with a little extra money each month. What should you do with that money? The question is should you use it for paying off student loans vs investing for your retirement?
People have strong opinions on both sides of the aisle. The general argument for using the leftover money to pay extra toward your student loans is that you get a guaranteed return for your money. You can know that you’re going to save a certain amount of interest with every extra payment you make.
And the general argument for investing your extra cash instead is that you could earn a higher return. Over the life of the S&P 500, it’s generated an annual return of nearly 10%. Since a large portion of student loans come with interest rates lower than that, many would say that the math is in favor of investing. Plus, you get the benefit of compound interest over time.
But the truth is that both of these opinions are too simplistic. In reality, the right strategy for your extra funds will depend on a variety of factors.There are a number of questions you should ask yourself to make the decision. Do you have an emergency fund? Any credit card debt? What type of student loans? The answers will help you decide if you are ready to start investing or if you need to focus on paying off your student loans.
Table Of Contents
- Do You Have An Emergency Fund In Place?
- Do You Have Credit Card Debt (Or Other High-Interest Debt?)
- What Kind Of Student Loans Do You Have?
- Are You Eligible For Student Loan Forgiveness?
- Do You Plan To Buy A Home Soon?
- Does Your Employer Offer A 401(k) Match?
- Which Choice Will Motivate You?
Paying Off Student Loans Vs Investing? 7 Questions To Ask
Ask yourself these questions to help you weigh the pros and cons of paying off student loans vs investing your extra cash.
1. Do You Have An Emergency Fund In Place?
If you don’t have an emergency fund in place yet, then the answer to the “Should I pay off student loans or invest” question is “Neither!” You need to focus on building up your emergency fund first.
Different people give different recommendations for how much money you should have saved in an emergency fund, but six months of living expenses is a good start.
2. Do You Have Credit Card Debt (Or Other High-Interest Debt)?
Once again, if the answer to the question above is “Yes,” then you shouldn’t be putting extra money towards your student loans OR your retirement savings.
Instead, you should focus on knocking out your high-interest debt first. According to the Federal Reserve, the average interest rate on credit cards is 15%. Many personal loans and business loans charge high-interest rates as well.
Student loan interest vs. investing interest is a worthy comparison since many student loans come with interest rates below 6%. But when you’re talking about high-interest debt (8% or more), there really is nothing to discuss. It’s a no-brainer decision. Pay off the high-interest debt first.
Related: Debt Snowball Vs Debt Avalanche: Does It Really Matter?
3. What Kind Of Student Loans Do You Have?
Are your student loans federal or private? If they’re federal, then your interest rates will be 7% or below. In fact, Direct Subsidized loans currently charge an interest rate of 4.53%.
If you have all federal student loans, it may make sense to focus on investing your extra cash instead of putting that money towards student loan repayment. But private loans tend to charge much higher rates. If you have private student loans, it’s probably best to prioritize knocking them out.
Finally, have you refinanced your student loans? If so, you could have a seriously low interest rate. Currently refinancing interest rates start around 3%. If you have student loan interest rates that are anywhere close to that low, putting extra money towards investing becomes a much safer bet.
Related: What are the Best Types of Student Loans
4. Are You Eligible For Student Loan Forgiveness?
It doesn’t make sense to pay extra towards your student loans if you’re going to receive forgiveness for those loans anyway.
Public Service Loan Forgiveness (PSLF)
If you work for a non-profit, you could receive full student loan forgiveness in as little as 10 years with Public Service Loan Forgiveness (PSLF). And, unlike income-based repayment forgiveness, you don’t have to pay income tax on your forgiven amount with PSLF.
If you’re pursuing PSLF, you should definitely NOT pay a cent extra towards your student loans. Medical professionals and government workers have the best chance of qualifying for PSLF. Teachers qualify as well. Speaking of teachers, they have their own dedicated federal forgiveness program. Let’s take a look at that next.
Teacher Loan Forgiveness
With the Teacher Loan Forgiveness program, you could receive up to $17,500 of student loan forgiveness on your federal student loans. To qualify, you’ll need to work for five years in an eligible low-income school. And, unlike PSLF, those five years must be consecutive.
There are numerous forgiveness programs for other professions as well, such as doctors, teachers, and lawyers. For example, medical professionals could be eligible for $30,000 to $50,000 of student loan forgiveness with the National Health Service Corps Loan Repayment Program.
Nurses could receive repayment assistance for up to 60% of their student loans with the Nurse Corps Loan Repayment Program. Lawyers could qualify for up to $60,000 of student loan forgiveness through the Department of Justice Student Loan Repayment Program. And members of the armed services could get up to $65,000 of student loan repayment through the College Loan Repayment Program.
If you’re pursuing any of these forgiveness programs, paying extra towards your student loans is like “robbing Peter to pay Paul.” Focus on investing for your retirement instead.
5. Do You Plan To Buy A Home Soon?
Most people know that their credit score plays an important role in whether or not they’re able to qualify for a mortgage.
But fewer people realize that there’s another key factor that lenders will look at–your debt-to-income ratio (DTI).
Most lenders don’t want your total monthly debt payments to take up more than 40% of your monthly income (although in some circumstances, Sallie Mae will accept a DTI of 50%)
How Student Loans Can Affect Your Eligibility For A Mortgage
What does this have to do with paying off student loans vs. investing? Well, imagine that you make $4,000 per month and you have a $400 car payment and an $800 student loan payment.
Next, imagine that you want to buy a house that would come with a $1,000 monthly mortgage payment. When you take $400, $800, and $1,000 and add them together, your total monthly debt payments would be $2,200. That would be over 50% of your $4,000 monthly income and you wouldn’t be able to qualify for a mortgage.
But now imagine that you pay off your student loans and that $800 per month student loan payment goes away. Now your total debt payments per month (including the mortgage) would only be $1,400. That’s only 35% of your monthly income and, in most cases, you’d qualify for the mortgage.
So if you plan to buy a home soon and your debt-to-income ratio is a concern, it may make a lot of sense to knock out your student loans as fast as you can.
How To Buy A Home With Student Loans
But what if your student loan balance is too large to pay off in the next few years? You may not want to wait that long to buy a home.
Sallie Mae recently announced a list of Student Loan Solutions rules that could help. With these new guidelines, lenders can now accept the debt amount on the credit report. Why does this matter? Because with the old rules, the lenders would use 1% of your total debt amount as your estimated monthly payment.
But if you’re on an income-based plan, your actual payment may be lower than that. Depending on your income, your monthly payment on an income-driven plan could be less than $100, or even $0.
With these new Sallie Mae rules, lenders can use that number when calculating your DTI. And that could make a huge difference in whether or not you qualify for a loan.
So if you’re not going to be able to pay off your student loans before you apply for a mortgage, you may want to join an income-driven repayment plan in the meantime. Then once you’ve bought your home, you could switch to the ten-year Standard plan or refinance your loans.
Related: How to Apply for a Mortgage While Pursuing FI
6. Does Your Employer Offer A 401(k) Match?
Some employers that offer 401(k)s to their employees, will also match a certain percentage of their contributions.
3% is a common 401(k) match percentage. In this case, if you contribute up to 3% of your salary, your employer will match that amount. That’s a huge deal because it effectively doubles the value of every dollar you contribute to your 401(k).
If your employer offers a 401(k) match, that’s free money that you really don’t want to leave on the table. In nearly every circumstance, you should contribute at least up to the match.
After that, you can consider whether you want the rest of your extra money to go towards your student loans or not.
7. Which Choice Will Motivate You Most?
Ok, so up until this point we’ve only talked about the math.
But let’s get real for a moment. While the math may be in favor of one side or the other, none of that matters if you won’t be motivated to put your extra money towards that cause.
Paying Off Student Loans: Could Be the Best Choice For The Goal-Oriented And Risk-Averse
We, as human beings, tend to be wired towards getting excited about debt payoff. With every payment we make, we see the number shrink and the finish line get closer. And that can help people get crazy excited about knocking out their debt.
But it’s harder to replicate that kind of experience with investing. The “end goal” is often harder to identify. And without that extra “oomph,” some people may conveniently find ways to spend their extra cash month after month instead of saving it for their retirement.
Paying off student loans will also be the best choice if you hate taking risks. With debt payoff, you can know that you’re going to get a return on your money. And, for many people, that could help them sleep better at night.
Related: Why You Should Look at Retirement as an Expense
Investing: Could Be The Best Choice For Math Nerds And Risk-Takers
I honestly think that the average person will fit into the category above. But I also realize that the ChooseFI readership often has different tendencies and passions than the average person.
And there’s a good chance that many of you reading this article are math nerds like me. And if you have an entrepreneurial bent, you may be perfectly comfortable with taking risks if there’s a chance of earning a higher return.
So, for all you fellow math nerds out there, these next few sentences are for you. Student loan interest payments are calculated with simple interest formulas. But when you invest, you get to take advantage of compound interest. So even if your investments only earned the exact same annual rate of return as your student loan interest rate, investing would still give you a better overall return by far.
If that little teaser excites you enough that you’re currently opening a new tab to run the numbers on investing and loan calculators, then you’re the kind of person who should probably use extra money to invest.
The overall point is to be honest with yourself about your tendencies and realize that the best plan is the one that you’ll actually follow through with. This really is the main thing to consider when contemplating paying off student loans vs investing.
The Bottom Line
As the questions above have helped you see, there is no one-size-fits-all answer to this question. There are a number of variables that need to be considered. And the right decision for you could be the wrong decision for someone else when thinking about paying off student loans vs investing.
If I were forced to give one answer to this question, I’d probably say that the ultimate strategy would be to do both at the same time! For example, if you have 300 extra dollars lying around each month, why not put $150 towards your student loans and $150 towards your retirement savings?
You’d get the benefit of the guaranteed return on your student loan payments with the hope of a higher return from your investments. Either way, you win.
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- Student Loan Debt Repayment With Travis Hornsby