Borrowers often ask us, what financial strategy should I focus on first? Paying off my student loan debt or contributing to 401(k) and/or other retirement investments?
Obviously, you want to start saving for retirement as early as possible to take advantage of compounding interest, but you’re also facing large student loan payments each month, every month, for the next 10+ years. So when you come by some extra cash (hint – like your tax refund!), should you prepay your student loans in order to save on interest payments in the long term, or do you focus extra funds on maximizing retirement contributions?
The overall financial strategy is quite simple… Will the return on your investment be greater or less than the interest you are paying on the debt? If you are paying more interest than you could earn from the investment, it makes more sense to focus on paying off the debt.
Here are some other questions you should ask yourself when choosing between paying off student loans or investing:
1. Do a quick personal financial check-up
Get acquainted with the factors lenders use to offer you credit. A few places to get started are by requesting and investigating your credit score, calculating your Debt-to-Income ratio, creating a budget, and performing a personal financial audit (think total assets and debts).
By getting a handle of these commonly used facts and figures, you’ll be able to identify whether you should focus on repairing your current financial situation or working towards your future investment goals.
2. Find out if you can get a better deal on your student loans
The first step is simply knowing your student loan terms – interest rate, repayment term, and the principle remaining. Generally speaking, if you have an interest rate above ~6% you might benefit from refinancing your student loans at a lower interest rate (Read: lower monthly payments and/or total interest accrued).
If you can your lower monthly debt payments and/or obtain a lower interest rate on your debt, the goal is to invest freed up cash in investments that earn higher returns than the cost of your debt.
Also, if you are currently on a 10 year repayment term, you can take advantage of varying repayment terms between 5-25 years via refinancing. For example, you can maximize the returns of this strategy by choosing a 25 year vs. a 5 year repayment term. Alternatively, a 5 year term would accrue the least amount of interest if you’re trying to payoff debt quickly and/or improve your Debt to Income ratio.
Learn more about your student loan refinancing options here.
3. Ask yourself how much you need to be saving (and how much free money you can snag)
On the retirement side, your first step is the same: understanding the bigger picture. Your plans for retirement may be very different from the next person’s, so make sure ask yourself where you financially want to be in 10, 20, or even 30 years from now.
There are several retirement calculators available online that take your age, salary, target retirement age, and other factors in order to spit out a savings number you need to hit. LearnVest also offers an affordable service to help you create a financial plan.
Armed with your numbers in mind, you’re nearly there in determining where to put your money. First, be sure to maximize your retirement savings. For instance, your employer may match your contributions to a 401(k). That’s free money every time you contribute, which could make retirement savings even more worthwhile in the short term.
Finally, plan out your student loans and retirement contributions alongside your other financial obligations, hopes, and dreams. Ultimately, everyone’s situation is unique.
Maxing out your student loan payments and retirement contributions may not make sense right now if you have a high level of credit card debt or if you want to put a down payment on a house. If you think you have more pressing financial goals to take care of, you should consult a financial planner before deciding where to spend your extra cash. Otherwise, congratulations! You’re one step closer to paying off your loans and retiring in style.
Kaitlin Butler is the Content Manager at CommonBond, a student lending platform where you can find her contributing to the community blog, @CommonBond, and Facebook. She’s passionate about personal finance and savings. Kaitlin’s articles have also appeared on Yahoo! Finance and LearnVest.
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