We’re often taught that the natural financial order is pay off debt, then invest. First you should pay off student loans, and invest your extra funds only after you’ve retired that college debt.
But is that really the best way to do things? Should you wait until you’re debt free before you start investing? Or is it possible for you to invest when you have student loan debt?
Should you pay off student loans or invest?
As with all things personal finance, there is no one one-size-fits-all answer. Look at your own situation and decide which course of action is right for you. Specifically, you’ll want to consider some key factors, such as tax deductions, forgiveness programs and expected investment returns.
Here, then, are a few things to keep in mind while you debate, “should I pay off my student loans or invest?”
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 reduce your ability to pay off your debt quickly and potentially force you to keep your loan longer.
On the other hand, interest can be a good thing when you’re earning it.
That’s what investing is all 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 4% and 8%. When you pay off debt, that’s like seeing a guaranteed return. So, if your average student loan interest rate is right around 5%, paying off your loans early is like getting a 5% return.
But what if you could get a return of 7% or 8%? 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 deductions for student loan interest
Another consideration is that investing — and as a result, keeping you student loans around a little longer — might come with an income tax benefit, if you’re able to take a deduction on your college debt.
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. When it comes to sheer numbers, the decision to pay off student loans or invest can be made by estimating your after-tax interest rate.
It’s possible to estimate your after-tax interest rate with this formula: student loan interest rate x [1 – marginal tax rate].
Let’s say your average student loan interest rate is 5%. You file as single and make $50,000 a year, putting you the 22% tax bracket for 2019. Plug the numbers into the formula to get 5% x [1 -22%] = 3.9%. So, basically, the interest rate you’re paying on your student loans comes out to that 3.9%.
So, if you can achieve an annualized return of 7% or 8% on your investment — especially if you can do so using a tax-advantaged retirement account — it would more than make up for the 3.9% you pay in interest on your student loans.
In this case, then, it might be wiser just to pay the minimum on that student debt and use the rest for investing (if you feel confident you can earn that level of return).
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 could just as well put that money to work for you through investing, especially if you can get a retirement match from your employer.
When you invest, you get a jumpstart on your retirement savings, even if you have student loan debt. And 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.
However, it’s important to pay attention to the forgiveness program you are considering. In some cases, it might not be worth it. For example, you could end up paying more interest, have a portion of your forgiveness subject to taxes or experience other consequences that could cost you in the long run.
What are your priorities?
Of course, not everything is about the numbers — you’ll need to consider other priorities as you try to decide whether it’s better to pay off student loans or invest. Some of your potential goals and needs might include:
- Saving up for emergencies: Some personal finance experts, like Dave Ramsey, recommend that you start by saving $1,000 in an emergency fund before you do anything else. You can bulk up the emergency fund later while working on other goals.
- Paying off other high-interest debt: Neither investing nor paying extra on your student loans will be as effective if you’re paying 17.99% interest on credit cards.
- Saving for retirement: Saving for retirement is one way to invest your money. If your employer offers matching contributions, taking advantage of free money to help you build your nest egg can make a lot of sense.
- Wedding: You might want to get married, and that can get expensive.
- Buying a house: Saving up for a down payment is another priority that can take precedence in some cases.
- Having children: You might be surprised at how costly it can be to have children, and that’s a priority to consider too.
Your priorities might be different from someone else’s. Consider creating a financial roadmap to help you take care of your priorities. Map out your goals and the timelines you’ve set for reaching them. It’s possible to work toward more than one goal at a time, so you can put more of your available resources toward the items most important to you now while still investing for the future.
How to invest when you have student loan debt
The good news is that there are great tools to help you start investing, even while dealing with student loan debt. Some tips to keep in mind include:
- Keep paying your minimums. First of all, you want to make sure you don’t end up in default — you should definitely keep paying the minimum amounts on your student loans.
- Consider consolidation or refinance. Chances are your student loans have several different payments and interest rates. To get them all under one roof, you can consolidate them using a federal program or — especially if you have private loans or loans with high interest rates — you can refinance them. In many cases, consolidation leads to a lower monthly payment (freeing up more money to invest each month, if you go that route). Student loan refinancing does too, and it can also potentially reduce your interest rate — use our refinancing calculator below to see how much you might save.
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. You might be surprised to discover that you can start investing with a small amount of money. In fact, some apps allow you to start investing with as little as $5. As your finances improve over time, you can increase the amount you invest.
- Make use of tax-advantaged retirement accounts. You can get the most out of your money by using tax-advantaged accounts. Start by investing in your company’s 401(k) if it has one. And if there is a match, try to do what you can to maximize it. You can also open an IRA or another account to help you invest more efficiently.
Repaying student loans vs. investing: the bottom line
There’s a lot to be said about investing, even when you have student loans. However, it’s important to remember that you run the risk of loss with investments, and your returns might not be enough to overcome your student loan interest, especially if you have high-interest loans.
Plus, 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, the decision to pay off student loans or invest is more about your peace of mind.
Figure out the best plan for you, based on your priorities, your level of comfort with student loan debt and whether your returns are likely to outweigh the interest you pay.
If you decide to pay off student loans before you invest, you could start your investments once the loans are paid off by putting all the money you had been using for repayment each month into a retirement account. This will help you catch up later on.
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