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Should I Pay Off Student Loans or Invest in Stocks?

Dan Caplinger, The Motley Fool

Getting out of debt and saving for the future are both important. Here's how to balance the two.
Image source: Getty Images.

A bag with a dollar sign on it sits next to stacks of coins with a graduation cap at the top.

Student loans are an obstacle for more than 45 million Americans, holding them back from investing for their futures. With as much as $1.5 trillion in total student loan debt outstanding, paying it down in full takes most people years after they graduate. This leaves them with less money to invest in the stock market, causing them to miss out on the gains that stocks have delivered over the long run. When you combine student loans with other debt like personal loans and credit cards, it can be even tougher for graduates to find the money to start investing.

It may seem like a no-brainer to get out of debt as soon as possible, but there are situations in which you'll end up better off in the long run if you're not in such a hurry to pay off your student loans. If you investing in the stock market while making your regular monthly payments on your student loans, the returns you'll earn from stocks are likely to be greater than what you'll pay in additional interest by choosing not to pay your loans off early.

The most important question to ask

In deciding whether to pay off your student loans faster or to invest in stocks, you need to weigh the benefits and costs of keeping your student loans outstanding. By considering those pros and cons of student loans, you can compare them with what you're likely to get by investing in stocks and then make a smart decision.

The stock market often moves up and down sharply over short periods of time, but when you back up and look at the performance of stocks over long periods of time, you can see they've delivered remarkably consistent returns of around 8% to 10% per year. That's considerably higher than the interest rates on most student loans -- and you can earn even better returns if you invest in stocks that outperform their peers.

However, that doesn't mean everyone should put investing before student loan repayment, because the benefits and costs of each type of student loan are different. For instance, while some student loans offer the following benefits, not all do:

  • Deferment of loan payments and interest while you're still in school or if you return to school after graduation.
  • Loan payment forbearance under certain circumstances.
  • Loan forgiveness if you enter certain professions or work in public service for a set period of time.
  • Access to income-based repayment plans that can make paying down student loans more affordable.
  • Discharge of any remaining loan balance upon your death.

For the most part, federal student loans are much more likely to have these favorable features than private student loans. Private lenders sometimes offer a few of these features, but you'll almost never see a private student loan that has all of them.

In addition, the costs of loans can vary dramatically:

  • Federal student loans tend to have relatively low interest rates that are tied to the prevailing rates at which the federal government can borrow.
  • Private student loans often have much higher interest rates. Some are designed to add a wide margin to prevailing interest rates, and others simply set an arbitrarily high rate.
  • The length of time you have to repay your loan can also have a substantial impact on the total costs you'll pay. Although the monthly payment on a student loan with a longer repayment period will be smaller than what you'll pay each month on a shorter-term student loan, it's likely that you'll pay much more in total interest over the lifetime of the loan if you go with the longer-term option.

All of this can make it difficult to decide whether to prioritize paying down student loans or investing in stocks. However, there are four simple steps you can follow that will usually get you the best result.

1. Take advantage of employer matching to invest in stocks

If you're fortunate enough to work for a company that offers an employer match on your 401(k) retirement plan contributions, then it pays to take full advantage of it. Many plans offer $0.50 or $1 in employer matching funds for every $1 you contribute to a 401(k), with the employer's contribution typically maxing out at 3% to 6% of your annual pay. Taking advantage of an employer match essentially gets you an instant return of 50% to 100%, which is all but impossible to achieve elsewhere. Thus it's usually best to prioritize investing in stocks through a 401(k), even above paying off student loans with the worst terms.

2. Get rid of high-interest private loan debt

Next, focus on paying off your highest-interest student loan debt. That typically means private loan debt with double-digit interest rates that make the 8% to 10% returns of the stock market look small. Given a choice, you'll usually want to concentrate on private loans that have the fewest beneficial terms, such as the potential for loan forgiveness or deferment.

3. Invest in the stock market

Once you have your high-interest debt paid down, the next priority should typically be to focus on investing. So long as the long-term expected returns of stocks are above what you're paying on your student loans, this alternative should leave you ahead of where you'd be if you paid down your lower-cost loans first.

4. Pay off the rest of your student loans

By leaving your favorable federal student loans for last, you'll be able to take advantage of their low costs as long as possible. At the same time, you'll be most likely to use the favorable features these loans provide. For instance, if you know your loan balance will be forgiven once you've worked at your job for a certain number of years, then it makes sense to keep that balance as high as possible to maximize the amount that will get forgiven. Paying it off early would essentially be throwing money away.

Be smart with your finances

Investing in stocks and paying down your student loans are both important milestones in your lifelong financial plan. By having a game plan for prioritizing these goals, you'll put yourself in the best position to end up with the financial security you need later in life.

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