We’re often taught that the natural financial order is pay off debt, then invest.
But is that really the best way to do things? Should your wait until you’re debt free before you start investing? Or is it possible for you to invest when you have student loan debt?
As with all things personal finance, there is no one right answer. However, you can look at your own situation and decide which course of action is right for you.
Here are a few things to keep in mind when deciding on whether you should invest or pay off student loans.
Compound interest is on your side
We tend to think of interest as a bad thing. That’s because most of us start paying it as soon as we hit adulthood.
For example, when you graduate with student loans or open your first credit card, a portion of your payment usually goes towards interest each month. This can ultimately slow down paying off your debt and may even force you to keep your loan longer.
However, interest can be a good thing — when you’re earning it.
That’s what investing is all about. It’s about putting your money to work on your behalf. Over time, that interest adds up to a lot more than you might think.
Your first consideration is whether or not you can get a better return through investing than you can if you pay down your student loan debt.
Depending on the year you took out the loans, and the type of loan you have, you might have an interest rate approximately between four percent and eight percent.
When you pay off debt, that’s like seeing a guaranteed return. So, if your student loan interest rate is five percent, paying off your loans early is like getting a five percent return.
But what if you could get a return of seven percent or eight percent? When you invest for the long haul, there’s a real possibility that your returns will make up for your student loan interest payments. And beat inflation to boot.
Tax deduction for student loan interest
Not only that, but you might also be eligible for a tax deduction on your student loans.
You may be able to reduce your taxable income by up to $2,500 depending on your eligibility. Added up over time, that can help make your interest less expensive.
Therefore, it may make a lot more sense to invest instead of paying off your student loans.
Student loan forgiveness programs
Don’t forget that you might also have access to student loan forgiveness programs.
What’s more, public service might even entitle you to student loan forgiveness without the worry of tax consequences.
If you plan to take advantage of such a program, making extra payments just to pay off your student loans faster might not make sense. After all, you might as well put that money to work for you through investing.
And, when you invest, you get a jumpstart on your retirement savings. Even if you have student loan debt.
Additionally, if the numbers add up and you’re going to be eligible for student loan forgiveness, you can position your finances for long-term success.
It’s important to pay attention to the forgiveness program you are considering, though. In some cases, taking advantage of the program might not be worth it. You could end up paying more in taxes or experience other consequences that could cost you in the long run.
Even investing might not help you as much as you’d like if you aren’t careful about the program you choose.
How to invest when you have student loan debt
The good news is that there are great tools to help you start investing. Despite student loan debt.
Here’s what to do if you want to invest while you have student loans:
Keep paying your minimums.
First of all, you want to make sure you don’t end up in default. Keep paying the minimums on your student loans.
Consider consolidation or refinance.
Look at your student loans. Chances are you have a bunch of different payments and interest rates.
Get them all under one roof. You can consolidate using a federal program, or you can refinance your student loans privately.
Once you are done, you might free up more money to invest each month. Use the calculator below to see if it’s the right option for you.
Student Loan Refinancing Calculator
Figure out what you can invest.
Decide how much you can invest each month while still making your student loan payments.
Make use of tax-advantaged retirement accounts.
You can get the most out of your money by using tax-advantaged accounts.
Start with your employer. Invest in the company 401lk. If there is a match, try to do what you can to get the best match possible.
You can also open an IRA or another account to help you invest more efficiently.
Your investment could pay off big, too. I refuse to pay off my student loans early because I have a low, low-interest rate. And, most of my interest is tax-deductible. Plus, I make much more investing.
Of course, if you have a high-interest rate, above say six percent, you might be better off paying off your student loan debt as much as possible.
That’s because your potential investment returns might not overcome the interest you pay.
It’s possible for you to determine whether to pay off student loans or invest using our handy calculator below.
Payoff VS Invest Calculator
Based on these estimates, you may want to prepay your loans rather than invest your extra funds.
Loan payback time
Assumptions: This estimation assumes you will pay a fixed amount every month to either your loan prepayment or to some type of after-tax or tax deferred investment. If it is after-tax it will be more available to you, but every 12 months you will be forced to pay tax on your annual yield. This also assumes that you take the extra tax savings by NOT prepaying (prepaying lowers your deductible interest payments) and you put the tax savings into the investment as well. This also assumes that the top income tax rate will stay the same for a long time. This tax rate should also include your state income tax too if applicable.
Should I pay off student loans or invest?
When it gets down to it, though, it’s not always about the hard numbers.
If you’re the type of person who can’t sleep at night because of debt hanging over your head, pay it off early.
Then, figure out exactly what you need to do in order to get a good start on saving for retirement. Consider starting an emergency fund, and then put the rest toward paying off that student loan debt.
I’m the kind of person who’s comfortable carrying low-interest, tax-deductible debt for 25 years. It doesn’t phase me. I sleep just fine.
But that might not be you. Even if it makes sense financially, you just might not be able to stomach it. And that’s fine.
You do want to make sure that you are planning for your future, though.
If you decide to pay off student loans before you invest, make sure that after you’re done, you put all that money you were paying on student loans each month into a retirement account. This will help you catch-up later on.
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