Pay Off Student Loans or Invest | The White Coat Investor (2024)

By Dr. Jim Dahle, WCI Founder

Ahh, you have finally made it. After four years in college, four years in medical school, 3-5 more years in residency, and 1-3 more in fellowship, you're finally making the big bucks. You've just started getting your first five-figure paychecks and you feel like you have some money that you don't need to spend on this month's necessities. You've got a couple hundred thousand dollars worth of student loans hanging over your head, a big mortgage, and even a little bit of credit card debt. But you're also looking at a huge tax bill, and besides, you don't want to work forever, so you've been studying up on 401(k)s and IRAs. You are financially at the place to ask yourself if you should pay off student loans or invest.

But how do you decide when to pay down loans and when to invest, especially now that the pandemic-era student loan holiday is over?

Should I Pay Off Student Loans or Invest?

It turns out it can be a pretty personal decision, and there are a lot of factors that come into play—including loan interest rates, current interest rates and inflation, expected returns on your portfolio, your current tax bracket, tax-sheltered accounts available to you, your attitude about debt, and your personal risk profile. I'll first discuss seven factors to think about, list 10 rules of thumb to follow, and finally give you 11 specific recommendations to help you decide when to pay off student loans and when to invest.

#1 Student Loan Interest Rates

The higher the interest rate on your loans, the faster you should try to pay them off. Remember to look at the after-tax rate of the loans. For instance, if you make less than a Modified Adjusted Gross Income (MAGI) of $75,000-$90,000 ($155,000-$185,000 married) in 2023, the interest on your student loans is deductible. If your marginal tax bracket (federal plus state) is 27% and your loan interest rate is 8% AND your interest is fully deductible, then your after-tax rate is 5.84%.

8%*(1-27%) = 5.84%.

Part or all of your mortgage interest may also be deductible for you.

Credit cards and car loans are not deductible. For many Americans and even many physicians, their best investment, no matter their tax bracket, is paying down high-interest-rate consumer debt. If your credit card debt is accumulating interest at 22%, you should pay that down as your first priority. That's a guaranteed 22% investment. You won't find that anywhere—with or without a tax break.

On the other hand, many of my med school classmates could refinance their student loans at less than 1% back in 2003. Although Dave Ramsey recommends paying off all your debts ASAP, many wise people are willing to carry non-callable debt at very low interest rates because of the opportunity costs you would give up by paying it off. What's the opportunity? It's the opportunity to borrow at 1% while earning 5% or even 10% on your investments. That arbitrage on $200,000 could be worth as much as $18,000 a year. That's not risk-free or tax-free, of course, but it can work out pretty well.

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#2 Current Interest Rates and Inflation

Hypothetically, if your loans are at 3%, inflation is at 4%, and your savings account is paying 5%, it is easy to see mathematically why you might not want to prioritize paying down that loan. Let me give you an example. In 1993, I took out a $5,000 loan for undergraduate studies. It was a great loan from my state with fantastic terms. It was 8% interest, but the interest didn't accumulate and I didn't have to make payments while I was in college . . . in medical school . . . in residency . . . or in military service. I paid off the loan in full in one lump-sum payment when I got out of the military in 2010, just before it started accumulating interest. I spent 1993 dollars, and I paid it back with the same amount of 2010 dollars. Of course, 2010 dollars were only worth 66 cents of a 1993 dollar. In essence, I borrowed $5,000 and only paid back $3,300, and I got to use the money for 17 years for free. Moral of the story? When you're borrowing money at rates below current levels of inflation or the long-term inflation rate, you might want to think twice before rushing to pay it back. The CPI year-over-year inflation rate can be found here.

Likewise, when you're borrowing money at rates below guaranteed safe investment rates (such as money market funds, CDs, or FDIC-insured savings accounts), you might not want to pay it back too quickly. Remember, of course, to adjust both rates for your current tax situation. Borrowing money at a non-deductible interest rate of 5% to invest at 6% (4% after-tax) isn't exactly a winning proposition. This is particularly a problem at times of low interest rates. If inflation is over 5% but you still can't get more than about 1% in a risk-free investment, then borrowing at 3% to invest in safe investments probably doesn't make sense.

#3 Expected Returns

I mentioned earlier that paying off a loan with 22% interest is a no-brainer. That's because the expected returns on investments available to you are nowhere near that. Don't believe me? Imagine a world where 22% after-inflation returns were available to investors. You could save 25% of your income for seven years and retire. Do you know anyone who did that? Me neither. Although estimates differ depending on who you ask, most experts agree that you can expect nominal (pre-inflation) stock market returns of 5%-10% over the long run and bond returns of 2%-5%. Naturally, those returns aren't guaranteed. It's one thing to borrow money at 3% and invest it at a guaranteed 5%. It's entirely different to borrow it at 8% and invest it in the stock market that may or may not beat that return.

An enlightening poll on the Bogleheads forum once asked at what loan interest rate an investor ought to invest instead of paying down the loan. The mean answer was 5%, but there was quite a bit of variation from 2% to 10%. I think 5% is about right. Most loans at an interest rate above that should be given a pretty high priority.

#4 Current Tax Bracket

Two investors might both have completely deductible 8% mortgages but differ in one important aspect. The first lives in Texas, and they are in the 12% federal tax bracket and the 0% state bracket. The second, in California, is in the 35% federal bracket and the 9% state bracket. The after-tax interest rate for the first is 7.04%, but it is only 4.32% for the second. The second might very reasonably conclude that they should invest while the first might decide to pay down the mortgage. That high tax bracket investor might also decide to invest instead of paying down the loan because they save a higher percentage of income by contributing to their 401(k) or other accounts. The Texan only gets a 12% tax break for 401(k) contributions, but the Californian gets a 44% tax break. Conclusion: The higher your tax bracket, the less anxious you should be to pay down debt over investing in a tax-sheltered account, especially tax-deductible debt.

#5 Available Tax-Sheltered Accounts

We saw above that the tax code can really mess with the loan vs. investment decision. The plethora of tax shelters available makes the decision even more complicated. For instance, I might prefer to invest in a 401(k) where I get a big tax break before paying down a 6% loan, but I might also prefer to pay down the loan before investing in a taxable account. A resident who expects to soon be in a high tax bracket might prefer to get more money into a Roth IRA where it will never be taxed again rather than pay down their loans. Even college savings accounts, UGMA accounts, and Health Savings Accounts offer some type of tax break to the investor. The more tax breaks available to you as an investor, the more you should lean toward investing instead of paying down loans.

#6 Attitude Toward Debt

Many of us hate debt, no matter the interest rate. I was listening to Dave Ramsey a number of years ago when a caller asked if he should use his spare cash to pay off his mortgage. Dave's suggestion was to pay it off. Then, in a few months, if he really missed it, he could take out another one. Obviously, nobody does that. There is a wonderful feeling associated with not owing anyone anything. Owning a house free and clear of the bank and knowing it can't be foreclosed on (as long as you pay your property taxes, that is) provides a great deal of security. Not having student loans also provides financial freedom in that you need less cash flow to service them and thus can work fewer hours, take a more attractive job that happens to pay less, or retire earlier.

There is also the behavioral factor. Many of us say we'll invest instead of paying down a loan, but in reality, we spend the money. Obviously, paying down a loan is more likely to help your bottom line than blowing your cash on something materialistic or fleeting. The more you hate debt, the more you should lean toward paying off your loans, even if the interest rates are reasonably low. If you think debt is the best thing since sliced bread, I suggest you read the tale of “Market-Timer,” a Bogleheads poster who managed as a grad student to lose a few hundred thousand dollars borrowed on credit cards and invested on margin in stock market futures.

The author and the WCI social media guru on top of the Middle Teton

#7 Personal Risk Profile

Investors differ in their need, ability, and desire to take risk. If you are a relatively conservative investor, close to retirement, or simply don't need to take on much risk (when you discover you've won the game, stop playing), you should pay off loans before investing. The less risky your portfolio and, thus, the lower the expected returns on it, the less sense it makes to carry loans while investing. For this reason, I think it is stupid to carry a mortgage into retirement. It is foolish for anyone to take on more risk than they can handle or than they need to take. As Warren Buffett likes to say, only when the tide goes out do you see who's been swimming naked.

Now that we have discussed some factors to consider and before we get into specific recommendations, I want to give you a list of guiding principles and rules of thumb to think about when deciding between paying down student loans and investing:

Paying Off Debt vs. Investing Guiding Principles

#1 Don't Leave Part of Your Salary on the Table

If your employer gives you a match in a retirement account like a 401(k) or 403(b), then be sure to get it. Not getting it is like rejecting part of your salary. Even if you have terrible, nasty debts, I would still contribute enough to get your full match. Think about it. If you get a 100% match on the first 3% of your salary (let's say that's $6,000), you contribute to the 401(k) and then you get an extra $6,000. Assuming immediate vesting, even if you turned around and pulled all that money out of the 401(k) and sent it to your lender, you would only pay a 10% penalty ($1,200) plus the taxes you would pay either way. If we assume a 25% marginal tax rate, that strategy would net you

$12,000 – 25% * $12,000 – $1,200 = $7,800

vs. $6,000 – 25% * $6,000 = $4,500

That's an extra $7,800 – $4,500 = $3,300. That's a no-brainer. Get the match.

#2 Don't Pay Off Loans Someone Else Will Pay Off

If you are going for Public Service Loan Forgiveness (PSLF) (meaning you made lots of tiny IBR/PAYE/REPAYE payments during residency or fellowship and are now employed full-time by a 501(c)3 anticipating tax-free forgiveness after 120 monthly payments), then don't send in extra money to your federal student loan lender. I've traditionally advised people to keep a “PSLF Side Fund” in a taxable account that can then be directed toward the student loans if PSLF gets changed and you're not grandfathered in or if you just don't want to work for a nonprofit anymore. However, it doesn't make much sense to invest in taxable if you still have tax-protected space like a401(k) or Backdoor Roth IRA available to you. I'd probably put it there. Sure, it's not going to allow you to instantly pay off those student loans in the event of a PSLF catastrophe, but you'll end up wealthier for preferentially using the tax-protected account.

#3 Stop Digging

Here's another somewhat obvious point. When you realize you're in a deep hole (debt), stop digging! I can't believe how many people are wondering how to get their student loans paid off while still borrowing money to buy other stuff. If it isn't a modest house or a practice, you probably shouldn't be buying it on borrowed money. That includes cars, vacations, living expenses, boats, pets, or anything else. Professional school will make you debt-numb. Wake up to its wealth-destroying effects on your life! Do you have $400,000 in student loans? Then, you're likely one of the poorest people in the world. The guy living under the bridge is richer than you. His net worth is $0. You should be driving a beater and living somewhere that feels very middle-class.

#4 Paying Off High-Interest Rate Debt Is a Wonderful, Guaranteed Investment

If you have high-interest debt, chances are good that you're not going to find an investment that will make that much money. You don't borrow money at 20% in order to invest because the risks you would have to take to attempt to beat that return are substantial. If you have debt at 20%, you should be paying it off as a major priority. In fact, you can probably lower that figure quite a bit. If you've got 8%+ debt, you're probably better off paying that down instead of investing. That's a guaranteed 8% investment. I wish I could find more of those.

#5 How Long Do You Want to Be in Debt?

Personally, I think you ought to have your education paid for within 2-5 years of completing your training. You're really not done with med school until you've paid for it. If you go much beyond five years, it will feel like a noose around your neck. You could have had the military pay for it and you would have been done in four years. To be out of debt that quickly, you're going to have to direct a substantial portion of your income to it. Calculate how much that is, and allocate that much toward the debt. Invest the rest.

But what if that doesn't allow you to max out all the accounts you want to max out? Tough cookies. Take more money from your lifestyle spending (i.e., Live Like A Resident), not from your debt pay-down money. That's not negotiable. You're getting out of debt in 2-5 years, come hell or high water. Now, if you want to keep your student loans for five years to max out some retirement accounts when you could get out of debt in two years without maxing them out, that's OK with me. But dragging your loans out for 15 years? I promise you're going to regret that. Those who lived like a resident when they should have will be financially independent by the time those who dragged out their loans are finally done paying for school. How are you going to save for your kids' schooling when you haven't paid for yours yet?

Once your student loans are gone, you can ask yourself the same question about your mortgage. Do you really want to be paying for that stack of bricks for 15-30 years? Figure out when you want to be done paying and make payments large enough to be done by then. Don't assume you can make big huge payments later (although there's a good chance you will, thanks to inflation, but certainly no guarantee).

#6 It Isn't Just About Comparing Rates of Return

Some people make this topic way too simple. They say, “If your investment is going to earn more than the interest rate of your student loans, then you should carry the loans and invest.” That ignores way too much. It ignores risk. It ignores the effects of taxes. And it ignores other important financial issues like asset protection, estate planning, and insurance costs.

Risk

If you can get 8% investing and have 7% loans, you should invest, right? No. That 7% is risk-free, and if you want a risk-free investment, you might only be earning 1%-2%. If you adjust for risk, paying off those loans is going to be the right choice. Now, if you're comparing an expected 8% return to a guaranteed 2% return, well, that's a little easier argument to make.

Another important consideration with risk is your need to take it. If you're a 55-year-old doctor with a net worth of $100,000, you have a substantial need to take risk (including leverage risk) if you expect to retire with anything close to your accustomed standard of living. If you're a 45-year-old doctor with a net worth of $4 million, you can afford the luxury of being debt-free. This consideration had a substantial effect on our decision to pay off our very low interest rate mortgage in less than seven years.

Taxes

Some types of debt are tax-deductible, and some types of investments are taxable at various rates. To compare apples to apples, you have to tax-adjust both sides of the comparison. You have to know your marginal tax rates (and there is likely more than one). If your marginal rate on ordinary income is 35% (you can figure this out with tax software) and your debt interest is fully deductible (you can figure this out with tax software too), then a 4% debt is really a (1%-35%)*4% = 2.6% debt. If your investment return is taxed at your marginal tax rate and earns 6%, then it is really 3.9% after-tax. If your investment return is taxed at a 15% long-term capital gains rate, then that 6% return is really 5.1%. Your marginal tax rate on the investment could be even lower if you can defer some of those gains (such as with a tax-efficient stock mutual fund) or if you have offsetting depreciation (such as with a real estate investment). And it would be zero if you're investing in a tax-protected account. Now, make your comparison.

In addition to those simple calculations, we also have to consider the other tax benefits of retirement accounts. For the typical attending physician in their peak earnings years, that mostly means a tax-deferred account like a 401(k). A typical physician should expect a tax arbitrage between their marginal rate at contribution and their effective withdrawal tax rate (35% and 15% would not be unusual). That has the effect of boosting your investment return significantly as you basically started with a free 20% return in the account. In addition, that money isn't taxed as it grows. That tax-protected growth may boost your return by another 0.5%-2% per year. And if you leave it to your heirs, it can be stretched for another 10 years. That tax benefit is awfully hard to pass up in order to get out of debt a few months earlier. Similar principles hold for a tax-free account like a Roth IRA, minus the tax arbitrage.

For the new attending physician, keep in mind you could delay retirement account contributions. Instead of contributing to the 401(k) or HSA in August, you could pay down debt in August and contribute in December. You have until April of next year to get in your IRA, SEP-IRA, and employer individual 401(k) contributions. Yes, you lose the benefit of having that money start compounding in a tax-protected way right away, but at least you don't lose that tax-protected “space” forever.

Clearly, it makes a lot more sense to carry debt to invest in a tax-protected account than to invest in a taxable account. When you're maxing out all your tax-protected accounts, that's a good time to take a look at the debts you have left and see if throwing some money at them would be wise. A 401(k) is a lot more valuable than most people think it is, and it is most valuable for high-income professionals.

Asset Protection

You should be familiar with the asset protection laws in your state, as it can have a serious effect on this decision. For example, in Texas and Florida, you have strong homestead laws, and it can make a lot of sense to pay down a mortgage since that money is protected from creditors. In my state of Utah, that would not be so smart since only a small portion of home equity is protected. But our retirement accounts get 100% protection. While a doc in Texas might choose to pay down a mortgage, a doc in Utah could, just as logically, choose to invest in a cash balance plan instead—even if expected returns were similar.

You can be assured that your creditors aren't going to take your student loans away from you. But money you use to pay them down also can't be taken away from you, and since they're not going away in bankruptcy, paying them off instead of investing in taxable is a smart asset protection move. Bear in mind that asset protection isn't nearly as important as most docs think it is. The risk of having a significant above policy limits judgment against you that isn't reduced on appeal is incredibly small.

Estate Planning

Retirement accounts are very useful for estate planning. By properly designating beneficiaries, that money doesn't have to go through probate. Of course, if you expect to die any time soon, you probably don't want to pay off your student loans, as they are generally forgiven at death (if you've refinanced, be sure to read the fine print to see if they're assessed against the value of your estate). Similar issues exist with disability as most student loans are forgiven in the event of permanent disability.

Cash Flow and Insurance

One of the best benefits of paying off debt is that your cash flow needs are lower. That allows you to carry less life and disability insurance to protect that cash flow. That could be worth hundreds or thousands per month.

#7 If Unsure, Split the Difference

As you can see, sometimes an invest vs. pay off debt dilemma is very straightforward to resolve. Other times, it is complex, murky, and dependent even on your emotional feelings about debt. In those times when you're truly unsure what to do and a discussion with those closest to you doesn't help, just split the difference. Send some of the money into your student loan lender and invest the rest and realize that you're choosing between two very good things to do. What you do matters far less than the percentage of your income going toward building wealth instead of being spent.

#8 Do Both by Living Like a Resident

Better yet, do both. I get this question most frequently from brand-new attending physicians. As they enter their career, they have so many great uses for money but only so much income to put toward those great causes. Think about a typical new attending and their uses for money:

Expanded emergency fund
Roth conversions of any tax-deferred savings from training
Max out retirement accounts
Pay off credit card debt
Pay off auto loans
Pay off student loans
Save up a down payment for a home
Save up a practice buy-in
Take a real vacation
Upgrade the beater

The new attending simply has to prioritize what is most important and then take any disposable income and work their way down the list until it runs out. However, that new attending will make it much further down the list if spending is minimized. That's why I encourage new attendings to live like a resident for 2-5 years out of training. If you can earn $300,000 while living on $50,000, that's $250,000 (OK, perhaps $175,000 after tax) that can go toward building wealth. Even $300,000 in student loans won't last two years if you are throwing $15,000 a month at them. A little sacrifice during the early career (that doesn't even really feel like a sacrifice yet because you have not yet lived on an attending income) will allow incredible financial freedom and perhaps even financial independence by mid-career.

To be honest, the most financially successful people I see are not choosing between their student loans and investing. They are doing both. At the same time. And doing both well. The blogosphere and social media love to debate these two options, but the reality is that the same traits that lead someone to save a lot of their money and invest it well also lead them to pay off their debts rapidly.

#9 Use the Power of Focus

Focusing on one goal at a time is a very powerful technique. The debt snowball method emphasizes focus and momentum. With this method, all available income is aimed at your smallest debt while minimum payments are made toward other debts. When that first debt is paid off, the borrower feels the momentum and redirects all that income toward the next smallest debt until it is paid off. Behaviorally, it is much easier to stick with a plan when you are doing one thing and you feel like you are accomplishing it rapidly. Since personal finance is 80% personal (behavioral) and only 20% finance (math), harnessing the power of behavioral finance to reach your goals seems wise.

#10 Use Student Loan Payoff as a Practice Run for Financial Independence

For a typical doctor, financial independence is a 15-30 year goal. Paying off student loans can be a 2-5 year goal. Aside from that difference, reaching the goals involves the exact same principles and discipline. In this respect, paying off your student loans rapidly is a trial run for becoming financially independent rapidly. When I see someone dragging out their student loans for 10, 15, or even 20 years, I worry they'll never become financially independent.

Priorities to Consider When Balancing Paying Down Student Loans vs. Investing

I suggest you use the following list of loan/investing priorities when deciding between paying down student loans and investing:

Get your match. Be sure to put enough into your employer-provided retirement accounts to get your entire available match. That's part of your salary
Decide how long you want to have student loans (generally 2-5 years). Figure out the minimum amount to pay each month to be done by that date. Additional payments toward this goal can be moved down this list depending on the interest rate. Obviously, if you are going for PSLF or IDR forgiveness, don't pay extra on your federal student loans.
Pay off high-interest debt. Any credit cards or consumer debt at 8% or higher should be paid off ASAP. Honestly, you should have never accumulated this. Live like a resident until it is gone. If you have 8%+ private student loans, refinance them ASAP and then you can move them down this list a bit.
Invest in tax-protected accounts. If you are a resident, max out your personal and spousal Roth IRAs. If you are an attending, max out your 401(k), SEP-IRA, HSA, and any other retirement account that allows you full marginal tax rate deductions.
Pay off non-deductible loans between 5%-8% (i.e., graduate student loans).
Consider investing in other accounts that offer a tax break, such as 529s (kid's college accounts), UGMAs, and Backdoor Roth IRAs.
Invest in risky assets in a taxable account (stock mutual funds or investment properties).
Pay off loans with after-tax rates of 3%-5%.
Pay off loans with after-tax rates below 3%.
Don't carry any debt into retirement. Losing the safety net of ongoing employment income makes this a risky affair. It's one thing to get foreclosed on when you're 30. It's entirely different when you're 70.

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