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Should You Pay Off Student Loans or Invest?

·8 min read
College graduation cap on cash
College graduation cap on cash

Pay off student loans or invest? It’s an important question to consider as the answer can shape your financial future. On one hand, throwing all of your extra money at student loan debt can help you relieve that burden faster. But waiting to invest could cost you precious time – as well as potential earnings – if you’re missing out on the power of compounding interest. Understanding your financial situation as it is now and what you’d like it to be, based on your goals, can help you decide how to best approach the pay off debt vs. invest debate. Be sure to consult with a financial advisor about the best way to handle the pay-off-debt-or-invest question.

Benefits of Paying Off Student Loans First

Student loan debt can be a roadblock to achieving other financial goals, including saving and investing. If your monthly payments are taking a sizable bite out of your income, then you may not have much money left to allocate to savings.

So paying off your student debt as quickly as possible could free up much-needed funds that you could apply to other goals. You could also save money on interest charges if you’re able to shave a few months or a few years off your debt repayment.

Here’s an example. Say you owe $30,000 in loans and you’re enrolled on a standard 10-year repayment plan. You have a 3.5% interest rate and your monthly payment is $330. At that rate, you’d pay $4,909 in interest toward your loans.

Now, assume that you pay an extra $70 per month to your loans, bringing your payment to $400. This would cut your loan repayment by one year and nine months and save you around $1,000 in interest. But what if you decide to add $200 to your monthly payments instead? You’d get rid of your debt five years and nine months faster and save more than $3,200 in interest.

Saving that much money could be a huge motivator to choosing debt repayment over investing. Beyond that, carrying student loan debt month to month can impose a psychological burden as well. You may feel bogged down by your debts and want to get rid of them as fast as possible.

When It Doesn’t Make Sense to Prioritize Student Loans

African-American college student
African-American college student

You may want to hold off on paying off all of your student loan debt if you’re trying to qualify for student loan forgiveness. Under the Public Service Loan Forgiveness (PSLF) rules, you could be eligible to have your remaining student loan debt forgiven after making 120 qualifying payments. This assumes you work in a public service career. If you plan to apply for PSLF then you’ll need to enroll in an income-driven repayment plan. This could lower your payment below what it would be on a standard repayment plan, allowing you to pay less toward your loans each month. You could then use the difference to invest or pay down other debts you might have.

In this scenario, paying off student loans before investing wouldn’t make financial sense. You’d get no benefit from paying more toward your loans if the goal is to have a good chunk of your student debt forgiven in the end.

Why It Pays to Invest Sooner, Not Later

Investing money is one of the keys to building wealth. When you invest money in stocks, exchange-traded funds (ETFs) or other securities, you have the opportunity to benefit from compounding interest. This simply means earning interest on your interest or investment gains over time. But it’s a powerful way to build wealth, especially when you’re investing over long periods of time.

Wondering how it works? Let’s reexamine our previous student loan repayment example. You know that if you pay an extra $200 a month toward your loans you can cut your repayment time in half and save $3,200 in interest. But what if you invested that $200 a month in a Roth individual retirement account instead and paid off your loans according to the 10-year timeline?

Assuming you earn a 7% annual return, the $200 a month you’re putting into your IRA could grow to $35,481 over that 10-year window. That can more than make up for the $3,200 you wouldn’t save on interest by paying your loans off early.

The longer you have to invest, the more you can take advantage of compounding interest. So, say you save $200 a month in your IRA from age 25 to 35 while paying off your loans. Once your loans are paid off, you increase your annual contributions to your IRA to $6,000. You save that every year from age 35 to age 65. You’d have $876,529 saved for retirement.

Likewise, the longer you wait to start investing the harder it is to catch up. So, assume that you don’t start investing until age 35. Even if you max your IRA out to the tune of $6,000 each year and earn a 7% annual return, you’d only have $606,438 to retire on. Five years may not seem like much in the grand scheme of things if you’re debating whether to pay off student loans or invest but it can have a bigger impact than you might think.

Pay Off Student Loans or Invest: How to Do Both

College student loan application
College student loan application

Paying off student loans while finding money to invest is doable; it just requires some planning. First, decide how quickly you want to pay your student loans off. If you want to cut your repayment time down from 10 years to five, for example, how much will you need to pay each month to make that happen? You can use a student loan calculator to run the numbers. Next, look at your budget. Is the number you came up with for student loan repayment realistic based on your current income and spending? If not, consider how you can cut expenses or increase income to find the extra money you need to pay off student loans.

While you’re finding money for student loan repayment, consider how much you can afford to invest. Remember, time is on your side so even if it’s only $50 or $100 a month to start every penny counts. And be smart about where you decide to invest.

For example, an online brokerage that charges $0 commission fees could be a great fit. The less you pay in fees to invest, the more of your returns you get to keep. If you’re interested in investing for retirement, you could open an IRA in place of or in addition to a brokerage account. With IRAs, you’ll want to pay attention to the expense ratios for mutual funds or exchange-traded funds you’re investing.

As you pay down student loans and invest, look for opportunities to increase your savings beyond your paychecks. For example, if you get refunds, rebates, stimulus checks or other windfalls you could split them between student loans and investments. You can sell things you no longer need or start a side hustle to create more money for debt repayment and investing.

Also, don’t allow free money to slip through your fingers. If your employer offers a 401(k) retirement plan, you could get free money to invest in the form of a company matching contribution. You can check with your plan administrator to find out how to enroll if you’re not enrolled automatically. You can also ask about the minimum contribution required to get the full match and how to increase contributions automatically each year.

The Bottom Line

Paying off student loans can be a great feeling but so can building wealth for the long term. Finding ways to balance both means being realistic about where you are financially, then weighing solutions to help you get to where you want to go next.

Tips for Financial Planning

  • In addition to your 401(k) plan, an IRA or a brokerage account you may be able to invest money through a Health Savings Account (HSA). This is a tax-advantaged savings account that’s offered high deductible plans. HSAs offer triple tax benefits since your contributions are tax-deductible, growth is tax-deferred and withdrawals for qualified health care expenses are tax-free.

  • Refinancing student loans could help you to reduce your interest rates and pay off your debt faster. This means taking out a new private student loan to pay off existing loans. Keep in mind that you may need a cosigner to qualify for the best rates if you don’t have a lengthy credit history. Also, take note that refinancing federal student loans into private loans means losing certain protections, including CARES Act benefits.

  • Consider talking to a financial advisor about how to balance paying off student loans vs. investing. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. It takes just a few minutes to get your personalized recommendations online. If you’re ready, get started now.

Photo credit: ©iStock.com/BrianAJackson, ©iStock.com/Damir Khabirov, ©iStock.com/courtneyk

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