Some of the most touted words of wisdom in personal finance are that it’s important to start investing as early as possible. Yet young professionals are struggling to start investing while still paying off student loans.
If you are paying down student loans – or any other debt – and are fortunate enough to already have some investments, you may be considering selling them to pay off your debt sooner. That could be a good decision, but there are several factors to consider before you hit the “sell” button.
Expected rate of return
Before selling any investments to pay off student loans or other debt, it is important to look at each investment, why you own it, and your expected rate of return.
Individual stocks, mutual funds, fixed-income (bonds), and real estate investments all behave differently. For one investment, you may expect to earn 5% per year, while another is projected to return 15% annually.
Clearly, the higher expected return is more valuable than the lower one, so if you do decide to sell something, make sure to start with the lowest returning investments first.
According to Warren Buffet, the smartest investment you can make is a low-cost S&P 500 index fund. Over a long time period, the S&P 500 typically returns 10% per year, or about 7% taking inflation into account.
Individual stocks are much less predictable. Even professional fund managers typically underperform the S&P 500; unless you are a rock star stock picker, assume your typical results will be the same or lower than the S&P 500 – and remember, you can’t predict what, exactly, those results will be.
The cost of your debt
Some loan interest rates are fixed, while others are variable. If you look at your most recent student loan statement, you can quickly find your current interest rate and whether it is fixed or subject to reset in the future.
Student loan interest rates for federal loans, which are fixed, range from around 4-7%, depending on the type of loan. The table below shows Federal loan rates for this school year.
If you have a loan from a private lender, average rates are typically around 9-12%. However, you might be able to refinance to a rate as low as 2.50% if you meet all the eligibility requirements.
Tax penalties and costs of selling investments
If you want to sell stocks to pay off debt, there is another cost to consider. Each time you sell an investment, you have to pay capital gains taxes if that investment had a positive return.
As of 2016, short-term gains are taxed at your regular income tax rate, most commonly around 25 percent. Long-term capital gains (held longer than one year) are taxed at 15 percent for most people.
If you have investments held in retirement accounts, such as an IRA or 401(k) plan, it is generally a bad idea to sell to pay off debt unless you are facing foreclosure or default. In addition to robbing your future self of valuable retirement assets, you are stuck with a big tax penalty on every dollar you withdraw before retirement age.
For instance, an early withdrawal from your IRA would incur a 10 percent tax penalty on top of capital gains and income taxes.
According to Fidelity, the total of taxes and penalties for early 401(k) withdrawals can approach 50 percent. And remember that in addition to taxes and penalties, you are giving up future gains in that account.
Do the math
No two people have identical loan and investment situations. If you want to sell assets to pay off debt, do the math for yourself before making a decision.
First, look at your loan interest rate and compare it to your expected rate of return on your investments. If you expect to get a higher return on your investment than the cost of your loan, you are generally better off keeping the investment.
Let’s take a look at an example of someone who is better off selling investments to pay off student debt.
Loan: Private student loan with an 11% interest rate and $10,000 balance.
Investments: Five stocks worth $2,000 each in a regular, taxable investment account.
In this situation, the expected annual return on the stocks is around 10% (or possibly lower due to the high risk of a non-diversified portfolio). Assuming a 10% return, the investor would earn $1,000 per year on these investments.
On the other hand, the cost of the loan is $1,100 per year. Selling the stocks to pay off the loan could be a smart decision, depending on how gains would be taxed.
Now, let’s look at an example of someone who should not sell assets to pay off debt.
Loan: Mortgage with 4.25% interest rate and $100,000 balance.
Investments: $110,000 invested in Vanguard S&P 500 index fund in a Roth IRA.
In this situation, it makes the most sense to look at the performance of each dollar, because the investor has enough in the IRA to completely pay off the loan with money to spare.
Each dollar borrowed costs 4.25% per year, or 4.25 cents. Each dollar invested earns 10% per year tax-free, thanks to the Roth, so each dollar invested earns 10 cents per year. Because the investment yield is higher than the loan cost, it is better to keep the funds in the IRA.
Should you sell stocks to pay off debt?
As you can see, there is no universal right or wrong answer. The key is understanding your own income, expenses, investments, and loans to make the best answer for your long-term financial success.
Whether you love budgeting or hate it, a budget is one of the best tools you can use to make a plan to pay off your loans. While you are trying to figure out what’s best for you, take a look at the invest versus payoff calculator to decide what to do with your next unbudgeted dollar.
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