College grads often wonder whether to pay down student debt first or to save for retirement. Financially savvy folks recognize the need to save for retirement sooner than later, but they also know the detriment of carrying a large debt burden.
To answer this quantitatively, you must compare your expected rate of return on retirement savings and your student loan interest rate. If you expect to make 8% a year on your retirement portfolio but your student loan interest rate is only 5%, it would be advantageous to maximize your retirement savings and pay the minimum on your student loan debt.
Consider a $10,000 student loan at 5% interest, with a minimum monthly payment of $106.07. We’ll assume you have $300 per month to put towards paying down that loan or investing in a retirement account with an 8% annual return. If you make the minimum payment on your student loan debt and save the remaining $193.93 for retirement, at the end of 10 years your student loan will be paid off and you will have $35,480 in your retirement account.
If you put all $300 per month toward your student loan debt, your loan will be paid in 3 years, leaving the full $300 to be put toward retirement for the next 7 years. At the end of 10 years, you will have $33,654 in your retirement account. Even with this sizable difference between the interest rate and annual return, the final balance differs by only about 5%.
There are 3 big problems with this simple answer:
- You have no way of knowing what your actual rate of return will be.
- The expected return will probably be fairly close to your student loan interest rate, making the decision even less clear.
- Even if you knew the actual rate of return over 10 years, you would have no way of knowing the volatility around that annual number. If you get 8% a year but the bulk of that return is in the next 2 years, it would certainly be advantageous to invest in retirement immediately. But if the return is zero or negative for the next couple of years, you may as well pay the student loan debt during those years.
Although there is no definitive answer, I believe there are several compelling reasons that drive people to do one or the other.
In favor of saving for retirement:
Taxes: Student loan interest payments are mostly tax-deductible. Maintaining a balance can reduce annual tax payments. 401(k) contributions and Roth IRA contributions are also tax-advantaged.
Inertia: There is some evidence that inertia is a powerful force in retirement finance. If you start saving for retirement now, you start to see the balance grow and it can be a virtuous cycle that makes you want to save more when you are able.
Rate of Return: Historical equity returns generally exceed student loan interest rates.
In favor of paying down student loan debt first:
Risk Aversion: You know what your interest rate is, but you don’t know what your rate of return might be. Risk aversion is a compelling reason to pay student loan debt first.
Psychological Benefit: For many people, paying down debt is important because it feels good. You can argue quantitatively all day, but people do what feels right.
No Good Alternative: Many believe that equity markets are overpriced. Bonds offer little to no yield. By paying student loan debt, you are essentially “guaranteeing” a rate of return equal to your interest rate. This may be the best alternative in a low-yield, overpriced market.
One important additional consideration is employer 401(k) matching contributions. If your employer offers a match, that pushes the balance in favor of saving for retirement. Continuing the example from above, assume your employer offers to match up to $200 per month in 401(k) contributions. Paying the minimum student loan payment and maximizing 401(k) contributions results in a 10-year balance of $70,959.
Paying the student loan debt first, you don’t receive the employer match for those first 3 years. The result is a reduced 10-year 401(k) balance of only $56,096. The match has a huge impact on retirement balances, because it’s a free return on your investment. For example, if you get a 50% match, think of it like an automatic 50% gain on your investment! If your employer offers a match, you should do everything you can to maximize it.
Also in This Issue:
Financial Service Providers: Part 2
88 Years of U.S. Stock Market Returns
The Randomness of Returns
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles
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