Everyone has a finite amount of money that they can allocate to their financial goals. One debate that always comes up in financial circles is should I pay off more of the principal on my mortgage or invest the extra money in hopes of earning a higher return than my home interest rate. A less frequently asked, but just as important question is should I allocate additional money to my student loans or invest it. The sooner you start investing, the more time your portfolio has to grow through the magic of compound interest. But if you wait to get started until your student loans have been totally paid off, you’ll miss out on a lot of that precious time.
Student loan payments are a financial challenge that will stare you in the face for decades to come and are a pressing debt that needs to be repaid. Missing a payment has the potential to tank your credit score. By no means should your student loans be deferred or put into forbearance in order for you to contribute to retirement because you’ll end up having to pay more later.
If you are struggling to make the minimum payments, and you’re okay with extending your repayment period, call your lender and see if there’s anything they can do to help reduce your monthly payments. Once you have that number, it can be a good idea to set up auto-payments so that you never miss one.
Let’s say you are a new grad with $30,000 in student loans debt (about average) and your student loans charge 3.86% interest (the current rate for federal undergraduate Stafford loans).
The minimum monthly payment, on the standard 10-year repayment plan, is $300. But let’s say you got a decent job and could put up to $500 per month toward debt repayment and savings combined.
We estimate a 7% return on your balanced investment portfolio. To keep the scenario simple, we don’t include taxes or rise in the model, and we assume you will retire in 40 years.
By paying $500/month on your loan, you will get rid of the debt in 5 years, 7 months. At the end of 40 years, if you continue to save $500/month, you’ll have a balance of $266,338 (adjusted for 3% inflation).
Say you pay the $300/month minimum on the loan and put the rest into your portfolio. Now, at the end of 40 years your portfolio is worth $274,385. Those five lost years of investing cost you a whopping $8000. You end up with more money in the end by paying off your loan slowly and investing early. It’s bet to hang onto your low-interest debt while you build your nest egg.
However, the flaw in this reasoning has to do with risk, by keeping your student loans around. You might lose your job and be unable to pay your loans, which would then go into default, rack up scads of penalties, and demolish your credit score. You should maintain an emergency fund in case you lose your job.
Your discretionary spending, or your larger fixed costs—think rent or utility bills—are probably better targets for downsizing before the money you’re investing in your future.
The bottom line is that while student loan payments must be made in full, it’s important not to let retirement savings fall by the wayside completely when money gets tight. You should calculate out how much you need to be saving to be on track for retirement, but keep in mind that if you can’t swing that amount right now, it’s better to start contributing something than nothing at all. Automate your contributions and when you get a raise, it’s the perfect time to consider accelerating your retirement savings.
Student Loans
