If you have a low interest rate on your student loans, some people say you should focus more on investing and less on repaying them early. Is that the best scenario? Or is debt repayment still the better option?
Let’s look at both sides of the debate and see which might work best for you.
The case for paying off your student loans as soon as possible
There’s often the belief that there’s little point in paying off a low interest loan. People often pay off other debts, and let student loans run their course. But there are several situations where you may not want to follow that strategy:
- Because you’re in a position to do so. This will apply mainly if your student loan debt is small, or you have the financial resources to pay it off in a short space of time. You may want to do this just to get the cost of your education behind you early in life.
- To gain greater control over your finances. Debt is a drain on your finances. A large debt is a big drain, one that can even leave you financially limited. By paying it off, you gain greater control of your income.
- To create more options later. By paying the debt off as soon as possible, you free yourself up to pursue other major goals. This can include investing. But there may be other goals, like a wedding, the purchase of a home, or the birth of a child. Student loan debt will hang over all those events, and by paying them off as soon as possible, you’ll create more options in your life.
- To “get the monkey off your back”. Millions of college graduates have been financially hobbled by student loan debt. The psychological impact of being debt-free is, for some, a huge draw.
No one likes to think about this, but if you have a rough series of bad luck in your life, you may be looking at the possibility of bankruptcy. But since federal student loans aren’t dischargeable, you may want to pay them off before you face such a circumstance. Otherwise your student loan debt may continue to haunt you, even after bankruptcy.
You can also look at it from a more positive angle. By paying them off, the likelihood of facing bankruptcy declines significantly in the first place.
The case for investing and letting your student loans ride
Student loan debts often carry low interest rates, low monthly payments, and extended terms. For example, a $30,000 student loan may have a 20-year term, and a monthly payment of less than $300. Next to a home mortgage, it’s probably the longest term that you have. That means it isn’t going anywhere anytime soon.
If the loan is particularly large, or you’re early in your career and don’t have sufficient income to pay it off quickly, you may simply have to get on with the rest of your financial life. That will include investing.
It could be argued that paying off student loans early vs. investing is a matter of “six of one, half a dozen of the other”, but that may not be remotely true.
The interest rate factor
If you have a very low interest rate on your student loans, you may be able to get a higher rate of return on investing than your paying on the loan. For example, if the interest rate on your loan is four percent, and you can earn a blended rate of return on a portfolio of stocks and bonds of eight percent per year, you’ll be better off investing in the long run.
For example, if you have a $50,000 student loan, with a 20-year term and a four percent rate, the monthly payment will be $303. That’s smaller than a typical car payment. By adding an extra $500 per month to your payment, the debt will be fully paid in about six years.
But let’s say instead you invest $500 per month—$6,000 per year—in a tax-sheltered portfolio earning eight percent per year? At the end of six years, you’ll have nearly $46,000 in your portfolio.
Meanwhile, your student loan debt will be paid down to $38,754. That means that after six years, your investment portfolio will exceed your student loan balance by $7,246.
The “starting early factor”
When it comes to investing, he who starts first generally ends best. That is, the sooner you begin investing, the more money you’ll have over the long-term. It has to do with the time value of money. The longer you invest, the more time your money has to grow.
Let’s continue the example above. You’re 22 years old and right out of college. You have the choice to either concentrate on paying off your student loan early in the next six years, or instead contributing to a 401(k) plan immediately.
If you delay the 401(k) in favor of paying off the debt, you’ll begin your 401(k) plan at age 28. Assuming you’ll begin saving $500 per month, by the time you reach 65, you’ll have just over $1,270,000. (For simplicity sake, were ignoring an employer match and annual pay increases, both of which will increase the final balance.)
If you go the immediate 401(k) route at 22, by the time your 65, you’ll have just over $2,062,000.
That difference in beginning your 401(k) of “only” six years is worth nearly $800,000!
Choosing where to invest your money
If you can choose where to invest your money, particularly with an IRA, there are several options available to you.
Robo-advisors are fully automated investment management services, that create your portfolio, reinvested dividends, and rebalance your asset allocations periodically.
One of the best is Wealthfront. Once you open an account with them, all you need to do is provide the funding on a regular basis and they’ll do all the work for you.
If you’re interested in self-directed investing, one of the top platforms is Fidelity. Not only do they offer a wealth of trading tools and resources, but they also provide very low trading commissions and virtually unlimited investment options.
If you prefer mutual funds and ETFs Vanguard is the biggest source of funds in the world. The funds will do the dirty work of investing for you, but shall have complete control over which funds you invest in.
Our recommendation in most cases is that you choose investing over paying off your student loans early. It will give you an opportunity to get into the game early, which produces the best long-term results. And if you do, give one of the investment platforms above a serious try.
- 5 Easy Ways To Start Investing With Little Money
- Should You Delay Retirement Contributions To Pay Off Debt?