Paying Off Student Loans vs. Investing: What To Consider
Between crippling student loan debt and slim prospects on the job front, today's college grads often struggle to fit things like saving and investing into the mix. When you've got a decade or more's worth of loan payments hanging over your head, figuring out the best way to allocate your hard-earned dollars is challenging to say the least.
Obviously, paying off your college loans before you get started with investing can take that burden off your shoulders but it's not without its drawbacks. Even though you're reaping the emotional reward of being student debt-free, you could be paying the cost financially by waiting to play the market. If you're able to free up some extra cash in your budget, investing early and often can definitely pay off in the long run. When it comes to paying off student loans vs. investing, recent grads don't necessarily have to sacrifice one for the other.
Safe vs. aggressive investments
If you have a low risk tolerance, you might assume that paying off your student loans is the best way to work towards your other financial goals. After all, once the debt's gone you can focus on saving for a down payment on a home or starting a family. On the other hand, if you're able to accept that investing may have its ups and downs, you can actually work towards your goals faster while you're chipping away at the debt.
Deciding how much risk you're comfortable taking on comes down to what you know about the market, the amount you're willing to put on the line and what your long-term financial vision looks like. Mutual funds or stocks can yield a bigger payoff than cash investments like a money market account or CD. You can then use those returns to accelerate your debt payoff or achieve some of your other objectives. Of course, there's more risk with mutual funds or stocks, so know what to expect before choosing this route. You don't want to lose more than you gain.
Weighing loan interest against potential earnings
The most basic truth about investing is that it's better to do it sooner rather than later. The longer you put it off, the less time your money has to grow. If it takes you 15 or 20 years to get your student loan debt wiped out, that's precious time wasted, especially when you consider the power of compound interest.
For example, let's assume you have $5,000 to make your initial investment and you can afford to chip in another $100 each month. If you start when you're 25 and earn a 6 percent return each year, it'll be worth nearly $250,000 in 40 years. Now, what if you waited five years to get started while you're paying off your loans? Assuming the same rate of return, your investment would be worth about $180,000, a shortfall of almost $70,000.
When you look at it that way, it's easy to see how much of a difference waiting to invest really makes. If you compare the amount of money you could be earning to what you're spending on interest for your loans, you're likely to see that the returns outstrip anything you'd save by paying off the debt faster.
Making your student loans more affordable
When you want to invest but your budget's the issue, finding a way to bring down the cost of your student loans is a practical solution. Grads who took out multiple federal loans can usually consolidate them into a single loan. Doing so typically lowers your monthly payment and it also reduces what you're paying in interest over time. Even if you're only able to free up an extra $50 each month, that's more money you have to invest. For grads who are saddled with private student loans, refinancing can yield the same results.
There are a number of lenders who specialize in refinancing private loans so you'll want to shop around before you make a deal. Take the time to look at what the interest rate is, whether it's a fixed or variable rate, how much your monthly payment would be and how long you'd have to repay the loan. If a refinance would lower your payment amount but tack on more time to your total debt payoff, you have to weigh the long-term cost against the benefits of investing.
Where to get started with investing
If you think you're ready to begin investing while you're still paying off your student loans, the biggest question is where to put your money. The most obvious choice is your 401(k), especially if your company matches a percentage of what you put in. Contributing the maximum each year is ideal but if you can't afford to do that right away, you can gradually increase the amount you're saving year by year as your loan balance dwindles.
For grads who are making enough to max out their employer's plan or whose job doesn't offer a retirement package, the next logical choice would be an individual retirement account. As of 2020, you could contribute up to $6,000 in a traditional or Roth IRA and both accounts offer some tax advantages. If you don't have a lot of cash to play with, investing in a solid mutual fund through a brokerage firm is a good place to start. Just be sure that you read the fine print so you're clear on what the fees are and what kind of projected returns you can expect.