If you’re fresh out of college and working a full-time job, you might be interested in investing your extra income.
After all, the thought of letting your money make money for you is appealing.
However, if you’re one of the many Americans with student debt, it can be hard to decide between investing and paying off student loans.
Compare both options to help you choose which is right for you.
The Case for Investing
Investing is important for securing your financial future. Investing your money wisely now will help you build an income stream that you can use during your later years.
There are many reasons you could argue that investing is the right choice.
Potential for strong returns
Investing your extra money gives you the chance to turn a small sum into a much larger amount of cash.
Even if you didn’t get lucky by picking a stock that skyrocketed in price, the market consistently offers good returns.
Over the past century, the stock market as a whole has averaged between 9% and 10% returns annually.
Of course, many years saw losses and many years saw much larger returns. But, if you can invest for the long term in a diversified portfolio, you give your money plenty of room to great returns.
Investing early means more time for money to grow
The story goes that Albert Einstein once said, “compound interest is the most powerful force in the universe.” By investing early, you give your money the chance to grow over a large span of time. The longer you let your invested funds grow, the better.
Consider the Rule of 72, which states that an investment which earns 7.2% interest each year will double every ten years. Money invested in stocks tends to grow at a higher rate, but let’s assume you earn exactly 7.2% in returns each year.
You invest $10,000 at the age of 25. When you’re 35, you’ll have $20,000. At 45 you’ll have $40,000. At 55 you’ll have $80,000 and at 65 you’ll have $160,000. Your initial investment will have increased by sixteen times.
Wait just 10 years to start investing, and you’ll wind up with just $80,000. Giving your money time to grow is the best way to build a nest egg.
Making use of tax advantages.
These tax-advantaged accounts let you deduct your contribution from your income when you file taxes, meaning you pay less tax.
You can contribute only a limited amount to these accounts each year, and you can’t make additional contributions to catch up on ones you missed. Any unused space is gone forever.
Of course, there are dangers to investing. If you choose to invest in a company that does poorly, you could wind up losing most or all of your money.
Investing also adds complexity to your taxes, making it more difficult for you to file each year.
The Case for Paying Off Student Loans
Student loans can be a heavy burden to carry, so there are many arguments in favor of paying them off.
Guaranteed interest savings
Paying off your student loans ahead of schedule means you’ll save money on interest. Instead of allowing interest to accrue over the life of the loan, you’ll stop it from accruing at all.
Consider this example.
You have $50,000 in student loan debt that you’ll pay off over ten years. The interest rate on the student debt is 5%. Over the course of ten years, you’ll make 120 $530 payments, for a total of $63,639 paid. If you come into $50,000 and use it to pay off your loan in one fell swoop, you’ll immediately save $13,639 in interest costs.
If you instead invest the extra money, your investments will need to earn at least $13,639 in ten years, otherwise, you’ll have come out worse by investing.
Relief from financial burden
Carrying debt of any kind is stressful and can really weigh on you. Debt can cause you to constantly worry about making payments, especially if you’re already short on money.
It’s a well-known fact that being burdened by debt can impact your relationships, self-confidence, and ability to plan for the future. Paying off debt tends to make people happier and less stressed.
Student loans are especially stressful because they can’t be discharged in bankruptcy. Even if you hit rock bottom, you can’t escape from student loans, so paying them off is like taking a weight off your shoulders.
Avoid variable rate increases
Some student loans, especially private loans, have variable interest rates.
That means that the amount of interest that accrues each month, and the size of your minimum payment, can change as market interest rates change.
The rate on variable rate loans is usually pegged to a specific rate, such as the London Interbank Offered Rate.
The LIBOR is the average of interest rates that English banks estimate they would be charged by other banks should they need to borrow money.
Usually, rates go down during recessions and when the stock market drops, and go up when the economy is expanding and stocks are rising.
If you decide to invest rather than pay off your loans, you could find your minimum payment rising as your stocks start earning their best return.
There are a few downsides to paying off student loans.
One is that student loans offer tax benefits, allowing you to deduct some of the interest you pay from your income at tax time.
That can reduce the effective rate on your loans by a lot, making them cost less than you think.
Paying off your loans also means you won’t get to take advantage of loan forgiveness opportunities, which could save you a lot of money if you’re eligible.
What’s the Right Move?
In general, paying off student loans is probably the wiser move, though there are a few exceptions.
Take advantage of your 401(k) match
Before paying off student loans, you should take advantage of your employer’s 401(k) match, if there is one.
Many employers will match 50-100% of your contributions, up to a certain percentage of your pay. This immediate return on your investment is too good to pass up on.
Invest if you have a stable income
If you have a very stable job, you can consider putting some money into investments rather than focusing on your student loans.
One of the main reasons to focus on paying your loans off is that you always need to make monthly payments.
If you lose your job, you’ll still be on the hook for payments each month. Once the loan is paid off, you don’t have to worry about coming up with that extra cash each month to make a payment.
If you feel very secure in your job and know you won’t lose your source of income, it can make sense to invest, so long as you think you can earn a higher return than your loan charges in interest.
Always build an emergency fund first
Before you make extra payments towards a loan or start to invest, you should build an emergency fund.
Your emergency fund can be the difference between being able to handle an unexpected bill without issue and going further into debt to handle the bill.
Picture this scenario:
You don’t have an emergency fund. You get hurt and have to visit the hospital and incur a $2,000 bill. Because you don’t have an emergency fund, you have two choices: use a credit card or don’t pay the bill.
Not paying the bill will ruin your credit and cause debt collectors to chase you down, so you decide to pay the bill with a credit card. Your card charges 20% interest and you make the $50 minimum payment each month. It will take you five and a half years to pay off your bill, costing you almost $3,300 in monthly payments.
If you instead had an emergency fund, you could have paid the $2,000 out of pocket, avoiding years of debt and more than $1,000 in interest costs.
If you get laid off, an emergency fund can also help you meet living expenses.
If you have $5,000 in the bank, that can get you through a few months of unemployment.
If you had sent that $5,000 towards your loan, you’ll still have to make your monthly payments, and you can’t use that money to buy groceries and other necessities.
A typical emergency should be equal to 3-6 months worth of living expenses. Ideally, it is held in an online savings account, where your money earns a high interest rate.
Consolidate your student loans
Another viable move is to combine your student loans into a single loan -- often a personal loan -- that offers a lower interest rate.
Essentially, you're paying off your student loans with the funds borrowed through the personal loan.
By doing so, you can reduce that amount of interest paid.
This step is best taken when your loan balances are close to being paid off completely. With the extra savings here, it opens up more cash flow for you to direct towards investing if you're comfortable with it.
Deciding between paying off loans and investing can be difficult. In general, it’s a better idea to pay off your loans.
However, a mix of investing and loan payments can also be a good thing to do. Just make sure you prioritize your emergency fund over either.