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Editor’s Note:In response to the coronavirus pandemic, as of March 13, 2020, the Trump Administration has halted interest payments on federal student loans. Please note that this applies to federally held student loans only and may not apply to your private student loans. Also note that student loan payments are still required, however your entire payment will now be made toward the principal of the loan. Check with your student loan provider for more information.
We all have limited funds at our disposal. So, using our moneyefficiently means making sound financialchoices. Whether we’re shopping for groceries or buying a car, every dollar spent means we have less to spend in other areas.
The same goes for student loans and investing. Sarah from Colorado recently asked us this:
Hi Holly and Greg,
I started abudget a few months ago and have cut my expenses. It’s wonderful, and I’m saving more money than ever!Now, I’m trying to decide what to do next. I’m considering using the extra money to payoff [sic] my student loans early, but I’m also thinking about investing more money in retirement or mutual funds. Do you have any suggestions?
First of all, bless you Sarah! We’re freakin’ ecstatic to hear that you’re taking charge of your money. Better yet, you’re going to use that money to get even further ahead. You deserve two snaps in “Z” formation!
Seriously, good work.
Should You Pay Off Student Loans or Invest?
Now, about your question. The thing is…it depends. I’d love to offer aquick and clean answer, but there are a gazillion different factors that couldinfluence your decision.So, before you choosewhether to pay off student loans or invest that money, let’s take a look at some of the things that should drive your decision.
Get Rates from Multiple Lenders – Whether you decide to pay off your loans or invest first, refinancing your student loans could be a great option. If you’re considering refinancing, Credible can help you compare rates from multiple lenders here.
Why It Makes Sense to Pay Off Your Loans First
Generally speaking, I’m of the opinion that debt blows. It crushes youemotionally and financially. When you’re in debt, part of every dollar you earn is spoken for. It destroys your ability to save and it limits your options–both with your money and your career. So, yeah, I’m typically firmlyin the “pay off your debt now” camp.
Shameless Plug: Holly and I just finished writing a book on this very subject. It’s called Zero Down Your Debt, and you can find it in stores now!
Beyond that, debt is dangerous. When you owe money, you put yourself in a precarious financial position. If you lose your job or aren’t able to work, there’s a good chance you won’t be able to make your payments. Student loans can be even riskier. In almost all cases, even bankruptcy won’t make them go away. That means you’ll be paying on those puppies for-ev-ah!
Additionally, paying off your student loans (and any other debt) could be considered one of the safest investments you can make. By paying off your loans early, you’ll be saving on interest. So, if you’re loan is at a 4% interest rate, you’ll effectively be keeping an extra 4% of your money by paying it off early. (Make sense?)
Finally, being in debt tends to perpetuate accumulating more debt. The fact that we already owe dullsour senses to the harm that debt causes.But when you’re out of debt, the last thing in the world you want is to rack up a new payment. Paying off your student loans quickly helpsyou enterthat state of mind in a jiff!
See Also: Compare the Best Student Loan Refinancing Rates Here!
Why It Makes Sense to Invest First
Although I abhor debt, there is an argument to be made for investing the extra money you’re saving. Depending on the type of loans you have and their interest rates, keeping your loans and investing your money may be the correct mathematical solution. By paying your loans off early, you could be losing money to opportunity cost.
So what is opportunity cost? Let’s look at an example to understand the concept. Suppose youkeep $10,000in a savings account. That’sfine and dandy, but you could be missing the chance to make additional money by investing it in the stock market instead.The loss of potential gain is called opportunity cost.
By paying off your loans instead of investing, you could bemissing out on the chance to make more in investment returns than you save in interest payments.The basic rule is this: If your interest rate is lower than your potential market gains, you should keep the loan and invest the rest. Mathematically, you’ll come out ahead…provided you actually invest your savings.
Digging Into the Numbers
So, let’s get a little more specific. We’re going to create a few examples which make some assumptions. Then, we’ll useLendEdu’s nifty new student loan calculators to run the numbers. Because “average market returns” are a bit misleading, we’ll use the Compound Annual Growth Rate (CAGR) over the last 60 years – which is roughly 6% – to calculate our expected investment gains.
Example 1
Assumptions: Federal Direct Subsidized Loan: 3.4% Interest Rate, Loan Amount: $35,000, Loan Term: 10 years, Extra Payment: $200/month, Market CAGR: 6%, Investments aretax deferred
Paying Off Student LoanEarly: According to the student loan prepayment calendar, our monthly payment on this loan would be about $345 per month. Bypaying an additional $200 a month, we would save $2,700 in interest over the life of the loan. We’d also pay the loan off 5 years and 11 months early. Not bad, right?
Investing the Extra Money: Using the “Student Loan Payoff vs. Invest” calculator, we find that paying off our loan early isn’t the correct mathematical choice. By investing that extra payment at a 6% return over the same time frame, we’d come out an additional $1,612 ahead.In this case, it is mathematically correct to invest the extra money rather than pay off our student loans early.
Example 2
Assumptions: Federal Direct PLUSLoan: 7.9% Interest Rate, Loan Amount: $35,000, Loan Term: 10 years, Extra Payment: $200/month, Market CAGR: 6%, Investments aretax deferred
Pay Off Student Loan Early: In this case, the calculator figures our monthly payment to be $423 per month. If we use the same $550 payment, we’ll still save $3,685 over the life of the loan and knock 2 years off of our term. However, if we keep our extra payment at $200/month, we’ll save a whopping $6,941, paying it off in just under 6 years. That’s a big chunk of change!
Invest the Extra Money: By investing the extra $200 instead ofpaying off ourstudent loans early, we’ll actually lose out on$3,604. Even if we use the same $550 payment, we still save $1,971by paying the loan off early. In this case, since the interest rate on the loan is higher than our expected return, we’ll save a lot more by paying off the loan early.
The Verdict
As you can see, when the interest rate on your loan is lower than your expected investment returns, the math dictates that investing supersedes any gains you’d get by paying your loan off early. If your interest rate is higher than any investment returns you can reasonably expect, paying your loans off early is the correct mathematical choice.
However, there’s more to it than just the numbers because numbers can be tricky. Basing investment return assumptions over a long period of time may not accurately predict what the market will do in the short-term. Yes, the average return may be 6% over the last 60 years,butstudent loan terms generally last only 5 to 10 years. That’s a very short investment window to play with. The market can swing wildly over such a short period, which could be good or bad for you. Often, the market falls short oftheaverage annual mark, while other times it goes far above. Over the course of decades, those swings even out. Over a shorter period, they may not.
Benefits available oncertain federal loans, investment advisor fees, and your emotional attitude towarddebt also must be considered. Plus, you actually need to use that extra money for investing – which is something many people actually fail to do. Spending the extramoney onconsumer goodsdoesn’t help you save on either front.
In my opinion, it’s never a bad idea to pay off debt. Although you mightmiss some investment gains, there is no doubt that you’ll save money. Better yet, you don’t have to guess how much you’ll save. Just use a student loan prepayment calculator and you’ll be able to see the concrete, real results that paying early will have.
Of course, there’s no reason you can’t do both. Pay some toward your loans and invest the rest. Doing both is just another way to diversify your financial plan.
What do you think? Do you prefer to play the numbers or would you rather go for the sure win? Let us know in the comments below.
(Disclosure: Some of the offers seen here are from companies from whom Club Thrifty receives compensation. This may affect the order and manner in which they appear. Rates are subject to change. Club Thrifty does not include or review all companies or available offers.)
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