William & Mary Convocation by Stephen Salpukas

Should I Pay Off My Student Loans Or Invest?

in Investing by

Are you one of the thousands of workers in the throes of paying off your student loans? Do you have the cash to pay off most of the debt now? Are you wondering which is the best use of your capital, pay off the loans or invest in the financial markets?

Learn about how to reconcile this common investing conundrum.

Student Loan Basics

If you’re like many millennial college grads, you amassed a few dollars in student loan debt. And the postponement of the payoff is a distant memory. Now, you’re conscientiously paying off the debt. Before we get into whether you should bite the bullet and zap the debt all at once, let’s review a few student loan basics. Here’s are you first three debts:

  1. Tally up how much student loan debt you have.
  2. Familiarize yourself with the important terms: repayment schedule (there are a range of repayment plans from 10 to 30 years), interest rate and minimum payment.
  3. Confirm what the grace period upon graduation is, which depends upon the type of loan. Federal Perkins Loans offer a juicy grace period of nine months. The Stafford Loans offer a six month grace period. The Direct PLUS loans have no grace period and repayment begins upon receipt of the final disbursement.

student loan payment interest rates

Loan Payoff Factors

Before deciding whether to pay off the loans or not, let’s examine some issues which will help make the decision easier. Like many financial decisions, there’s no “right” answer for all, but understanding the facets of the payoff versus invest decision, makes it easier to chart the course that’s right for you.

Loss of Liquidity

In economics this is referred to as the “opportunity cost”. Whenever you make a decision to take an action, you are simultaneously deciding “not” to take another course. Thus, assume that you have $25,000 in student loan debt, and $25,000 available cash to pay off the debt. Further assume that you have an additional amount saved of at least six months of living expenses in an emergency fund.

Do you take the $25,000 and pay off the debt? If you go that route, then that $25,000 is not available for alternative investments. Before grabbing your checkbook and paying off the debt, understand the “opportunity cost” or other uses for that money.

As we continue with this example, I’ll review the information you need to decide whether you are better off financially to zap the debt or to invest the money.

Interest Rate on the Debt

The first factor to consider is your interest rate. The higher the interest rate on the student loans, the more the scale tips in favor of paying off the debt. If the interest rate on the loans is lower, it may be financially beneficial to pay off the student loans more slowly. If you think you can earn a greater return in the markets than the interest you are would be paying off on the debt and invest the capital in the financial markets.

What Return Do You Expect in the Financial Markets?

If you expect the return on your investments to be higher than the interest rates on the debt, then it may be financially beneficial to hang on to the low interest rate debt and invest.

While you can predict with certainty what your interest rate is going to be, predicting the future returns on your investments is not as easy. The return on the S&P 500 during the past five years has varied meaningfully, as shown in the table below:

Historical Market Returns

 

So how does one determine what their long term investment return will be?

While it’s impossible to predict your future investment returns, we can at historical market performance as an indicator.

We can look at the S&P 500 as a proxy for equity market performance. While the past five years have shown a fantastic 18.2% average return, the average annual S&P 500 return over the long-term was 11.5% (the compounded annual growth rate over that time period is slightly less, at 9.8%). For fixed income, we can look at historical 10-year Treasury Bond returns. From 1928 to 2013, 10 year Treasury bonds returned 4.9% (the compounded annual growth rate is slightly more, at 5.1%). But the last five years gave investors a subpar 1.5% average annual return.

For a simple portfolio return calculation, let’s assume you’ve got a portfolio that is 60% stock and 40% bonds. (Note: Personal Capital recommends including more asset classes in your portfolio). For stocks, let’s use the long-term compounded annual growth rate of the S&P 500 (9.8%). For bonds, let’s use the compounded annual growth rate of the last 5 years (1.5%) to be more conservative. That gives you an expected portfolio return of 6.5%. That may be higher than your student loan rate.

So should you invest instead of paying off your debt? There are a few factors left to review besides investment returns versus interest rate. But before I continue, let me pause first by repeating what I began this section by saying: it’s impossible to predict your future investment returns. Your student loan interest rate, on the other hand, is possible to predict. By trying to earn money on the spread between your investments and your loans, you risk losing money.

Can You Deduct the Student Loan Interest Payments?

One other reason to keep your loans around is that you may be able to deduct interest you pay on a qualified student loan. Generally, the amount you may deduct is the lesser of $2,500 or the amount of interest you actually paid.

This is another factor in the paying the loans off over time column. If you can get a tax deduction each year, it may be beneficial to pay your loans off more slowly.

Psychological Considerations of Paying off Student Loans Versus Investing

Are you one who abhors debt and will always feel uneasy with student loan debt? If you feel that debt is a weight around your neck, then you may want to pay off the student loans to be free of the debt.

Are you risk averse and ill-suited to watch your investment value go up and down? If that sounds like you, then that’s another reason to get rid of the debt and wait to invest.

On the other hand, if you’re comfortable watching your investment portfolio value go up and down, and interested in maximizing your potential financial gain, in spite of the risks in investing, then investing while paying off the debt, may be a better alternative if the interest rate on the loans is lower than the projected investment returns.

Free Money Consideration

As if this decision wasn’t already complicated enough, there’s one more factor to consider.

Does your employer match your investment into the company 401(k)? If so, then in most cases, you are well advised to contribute enough to the 401(k) to get the employers contribution.

Should I Pay Off Student Loans or Invest?

In most cases, it’s a good idea to do both. It’s generally always a good idea to diversify your investments.

The earlier you start saving for retirement, the more time your money will have to grow and compound, and the easier it is to build up a substantial nest egg. Unless the student loan debt is ruining your psychological life and you are willing to put most other financial priorities on hold, then it’s preferable to take a more balanced approach.

In the beginning stage of your adult life, there are a myriad of possible financial priorities; saving for a home, paying off debt, starting a family, and more. It’s usually better to simultaneous contribute to all of your financial goals.

When paying off any debt, prioritize higher interest debt over debt with a low interest rate. The strategy is to earn more money on your investments than you are paying in interest. Pay off the highest interest rate debt the most aggressively, and the lower interest rate debt more slowly. For example, if your projected investment return is 6.5% and the interest on your debt is 4.5%, then you are gaining 2% (6.5%-4.5% by not paying off the student loan right away).

Contribute at least enough to a workplace retirement plan to get an employer match. Would you turn down free money? Of course not, yet that is what you are doing when you don’t claim the employer contribution into your retirement plan.

Even if you don’t get an employer match, you may want to consider saving for retirement as soon as possible.

Finally, make sure you have at least a 6 month cash cushion for the unexpected. Because something always comes up. For a related post, please see, “Pay Down Debt Or Invest? Implement FS-DAIR“.

Photo Credit: Convocation at W&M by Stephen Salpukas

Use Personal Capital’s free financial tools to help manage your portfolio.

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Barbara Friedberg

Barbara Friedberg

Barbara Friedberg, MBA, MS is an investment portfolio manager, former university finance instructor, and website publisher at Barbara Friedberg Personal Finance.com. Her recent book, "How to Get Rich; Without Winning the Lottery", is available on Amazon. Barbara excels at teaching wealth building through investing. You can follow her on Twitter at @barbfriedberg

24 comments

  1. Financial Samurai

    Barbara,

    Nice article. It’s good to hedge as one never knows what expenses might come up. I paid off my b-school loans in the fourth year because I simply got sick of it, despite the interest rate at under 3%.

    It’s the annoyance factor that really got to me. Like investing, paying off a little here and investing a little here is probably the safer and best way to go.

    Sam

    Reply
  2. Barbara Friedberg

    Barbara Friedberg

    Sam, As in most finance (and life) activities, balance is usually a sound strategy. Fortunately, I had no student loans, but my daughter paid off her’s as soon as she graduated since she didn’t want them hanging over her head.

    Reply
  3. Little House

    For me, I like to be balanced. Paying off debt while investing and saving is what I have done. I think for many people, this is a better strategy than focusing on only one thing at a time. However, there are others out there that probably prefer to focus on debt repayment before saving and investing. That’s fine, as long as the debt repayment process doesn’t take longer than 3-4 years.

    Reply
  4. Barbara Friedberg

    Barbara Friedberg

    @Little House-Balancing debt repayment and saving can be a sensible strategy; especially when it comes to student loans. Although, I usually recommend eradicating high interest rate credit card debt as quickly as possible.

    Reply
  5. Jorge

    I am leaning toward a accelerated repayment due to credit considerations. I believe my score is much lower than it should be because of the loans.

    Reply
    • BARBARA FRIEDBERG

      Jorge,

      It is certainly a good idea to try to payoff the loans as quickly as possible, if you can. If you believe that the loans are hurting your credit score, that’s motivation to get them off the books as quickly as possible.

      Reply
  6. Michelle

    This is a constant discussion in our household. I feel like I don’t want to start investing until we have our loans paid off so we have more money to use. My husband, on the other hand, is the opposite.

    Reply
    • BARBARA FRIEDBERG

      Michelle, Each situation is so personal. As I mentioned in the article, if one of you has a 401(k) plan with a company match, it’s usually a good idea to invest in order to get the free money. It also depends upon how long it will take until the debt is paid off. For example, if the student loan debt won’t be paid off for ten years, then that is a long time to wait before beginning to invest since the power of compounding is so important in growing your investments for the future.

      Best of luck.

      Reply
  7. Heather

    Thanks for the article. My student loan interest rates are low but my total is $210K and I’ve been paying for about 5 years of a 30 year repayment. I’m doing okay saving and investing but I want to buy a coop/condo in NYC. While I have a decent down payment and excellent credit score, I’m having trouble getting a home loan due to my student loan balance. Not sure if I should pay down the debt quicker or use that money to add to my down payment.

    Reply
    • BARBARA FRIEDBERG

      Heather, You’re in a tough position. I think this is a question for the lenders. But, since you said you already have a decent down payment for your future. home, it may be wise to consider paying down the loans. Also, whenever applying for a loan, it’s helpful to write a personal letter explaining your situation and credit worthiness.

      Reply
      • Flabanker

        Usually the debt amount is not the issue when bankers evaluate your ability to repay your debt. Don’t just throw money at the existing principal balance, rather restructure the entire loan to lower your monthly payment based on a resulting lower principal balance. Personally, I think a bigger down payment on your current request would be the best course of action to take.

        Reply
        • BARBARA FRIEDBERG

          @Flabanker, Given your handle, I’m assuming that you are a Florida banker? Is that correct? Thanks for your opinion. If you are a banker, do you think your remarks are generalizable to other banks in other states?

          Reply
  8. leon

    Great article and helpful information. Just wanted to point out that the student loan interest does not apply to those who make over 65,000 as a single individual.

    Reply
  9. Troy

    Barbara,

    I think you are missing one important aspect, that is risk adjusted return. While it is true that investing can get you a larger return over time, one also has to consider the risk that comes with the potential to achieve that return. Paying off student debt is a risk free return (one that could be as high as 8.5%). There are not to many guarantees in investments and certainly not any that I can think of that come with an 8.5% interest rate. The picture of investing also looks much better with the markets a all time highs, this image would have bee quite a bit different if you had provide the investment returns in early 2009 and the 5 and 10 year averages were negative.

    Reply
    • BARBARA FRIEDBERG

      Troy, You raise some important considerations. It’s difficult to speak in specifics as loan interest rates vary per the individual. Some people have very low interest rates on their student loan debt.

      That said, I do agree that it’s important to be cautious now plunking a large investment into the stock markets today, with valuations above average. Yet dollar cost averaging over time is usually a sound strategy when investing.

      LIke most personal finance decisions, there’s no one right answer for everyone.

      Reply
  10. D

    PLEASE! Nobody use the “I want the tax deduction” logic in deciding whether to pay a student loan more slowly. That’s just like saying “I’ll pay you $10 if you’ll give me $1.

    Reply
  11. Josh

    There are loan forgiveness programs e.g. public service loan forgiveness, PAYE, and IBR which can weigh heavily in favor of investing over paying down a student loan balance.

    Reply
  12. BARBARA FRIEDBERG

    Josh, thank you for adding to the possible resources for students with student loan debt.

    Reply
  13. Chris

    This is a constant debate in my head. I’ve recently struggled with the thought of pros/cons of adding a 529 for our 2 children under the age of 3. Does it ever make sense to start saving for their college before paying ours off? We have a little less than $70,000 in school loans yet; half of which are at 2.35% with no immediate plans of paying more than the minimum there. Doing the budget for next year, it appears we can pay off the lowest balance if we hit it aggressively. We will still contribute to 401ks above the company match level, but wouldn’t have much left over. With the idea of not missing out on “free money” at heart, I’ve decided to start with $20/month in a 529 to begin taking advantage of compound interest and/or dividends reinvested. We live in a state without income tax, so that was another factor that delayed things.

    Reply
    • Financial Samurai

      2.35% is a great rate! I would lean 70% invest / 30% pay down loans every single month given the historical return in the market is multiples higher than 2.35%.

      Reply
  14. Kevin

    $12k in student loans ranging from 3.5%-4.75%
    $20k in checking/MM
    $9k in equities

    Currently contemplating the same.

    Reply
  15. BARBARA FRIEDBERG

    “$12k in student loans ranging from 3.5%-4.75%
    $20k in checking/MM
    $9k in equities

    Currently contemplating the same.”

    @Kevin, Thanks for sharing your portfolio. It looks like your financial picture is sound and your student loan debt is reasonable. Let us know what your plan is between paying off debt and/or investing?

    Reply
    • Chad

      Hi Barbara,

      I have $50,000 in student loans. The interest rates range between 4.25 to 6.75%. I have $160,000 in cash/investments that are not related to my retirement. Should I pay the loans off or continue to invest?

      Reply
      • Barbara Friedberg

        Chad with the debt interest rates between five and seven % & the market at a peak I would lean towards paying off the student loan debt, or at least a big chunk of it. I’d be cautious about investing a lot of cash at current market valuations.

        Reply

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