Pay Off Student Loans or Save for Retirement?
Whether you should pay off student loans or save for retirement depends on your financial situation. Typically, you should consider whether your expected return on investment or your student loan interest rate is higher to decide.
When you have extra income at the end of the month, you need to decide what to do with it. That money should ideally go towards accomplishing your financial goals—but you probably don’t have just one goal you want to achieve.
In fact, you may have many items on your financial to-do list, including both paying off student loans and saving to fund your retirement plan. Many Americans add paying off credit card debt to those goals or putting aside an emergency fund, making it even more complex.
Since most people don’t have unlimited cash, you’ll have a personal finance choice to make when it comes to deciding whether to put extra money towards student loan debt or towards retirement savings.
Unfortunately, there’s no one right answer when it comes to how you should prioritize retirement savings over debt repayment. The best course of action will depend upon your personal situation.
To help you decide if it’s best to pay down student debt ASAP or put at least some of your spare cash into a retirement account instead, check out this guide below.
You can also use our Pay Off Student Loans or Invest Calculator to work out the math for your personal situation.
When it Makes the Most Sense to Pay Off Student Loans
Making extra payments on your student loans can help you get them paid off faster. This could save you money on interest in the long run and help you in your financial life. You should allocate most or all of your spare cash to paying more than the minimums on student loans in a few key situations.
When Your Interest Rate Exceeds Likely Investment Returns
Choosing to put most or all of your extra money towards student loan repayment makes sense if the interest you’re paying on your student loan debt is higher than the returns you can reasonably expect to earn from investments.
In most cases, it’s reasonable to expect around 7% to 8% returns if you invest in the stock market. And you could earn more, as historically the average return of the stock market is around 10% annually. Of course, this is an average return over time, as the market has up years and down years. When you’re investing for retirement, you’re a long-term investor, so you should expect to come close to these average returns.
If you could earn 7% to 10% per year on investments made for retirement and your student loans payments are costing you 6% interest, it makes no sense to pay them off early since the amount your investments could earn exceeds the interest you pay. But if your loans are at 18%, you can’t expect to earn investment returns anywhere near that high, and you should focus aggressively on paying your loans.
When You Can’t Refinance Your Loans
If your student loans are at a high interest rate, refinancing them to drop the rate makes sense so you’re able to start investing for retirement ASAP.
If you aren’t able to refinance student loans, making loan payments and paying them off early would be a higher priority since you won’t be able to reduce the interest you’re paying.
When Becoming Debt-Free Is a Top Priority
Some financial advisors recommend trying to become debt-free before focusing on significantly on your retirement fund such as a Roth IRA. If you really hate being in debt and you’re extremely motivated to pay off your student loans, it makes sense to do that first. This is especially true if it won’t take you long to get your student debt paid down when you throw extra cash at it.
If you can quickly pay off your debt, you’d have more money to allocate to retirement investing. Those extra investments could help to make up for the delay in getting started on retirement savings caused by paying off student loan balances early.
When it Makes the Most Sense to Save for Retirement
It’s important you start to save for retirement as soon as you can as part of your financial planning. The sooner you begin saving, the more compound interest can work for you.
Compound interest is earned when you earn returns on investments, those returns are invested, and now you earn returns on that additional money. If you invest $100 and earn a 10% annual return, the next year you have $110. You now earn a 10% return on $110 instead of on $100, so in year two, you earn $11 from your investments instead of $10.
So, when does it make sense to devote your extra cash to retirement savings so you can start earning compound interest?
When You Can Earn More from Your Retirement Investments Than Your Interest
If you think you can earn more from investments than you’re paying in student loan interest, you should pay the minimums on your student loans and put the rest of your spare cash into retirement accounts.
When you repay student loans early and make more than the minimum payments, you know exactly how much you’re saving on interest because you know what your interest rate is. When you invest, the rate of return you’ll earn is uncertain. And there’s a tradeoff between risk and return, with high risk investments having the potential to earn better returns but also presenting a greater risk of loss.
You’ll want to invest in a diversified mix of assets and take reasonable risks, especially if you’re prioritizing retirement investing over student loan repayment. It can be a big disappointment to devote extra cash towards retirement accounts and then lose the money due to bad investments while you’re stuck paying student loan interest.
When You’re Going to Get Loans Forgiven
If you’re working toward Public Service Loan Forgiveness and the remaining balance on your federal student loans will be forgiven after you make 120 on-time payments, there’s no reason to pay even $1 extra towards your student loans.
Instead, you should pay the minimum required and focus on putting any extra money towards your other goals.
When Your Employer Offers a Match
In many cases, employers match contributions you make to a 401(k). If your employer offers you a match, this is free money. You should always prioritize investing up to the amount you need to earn the match, as this gives you a 100% return on your investment.
>> Read More: Should you max out your 401(k)
Focus on earning the employer match even if your student loans are charging a high interest rate. Pay the minimum on your loan to avoid default, then put the extra cash into retirement savings.
When You’re Eligible for Tax Deductions
Unless your income is too high, you can deduct up to $2,500 in interest paid towards student loans each year. If you are deducting student loan interest, it’s costing you even less—and it makes even less sense to focus on paying down student debt instead of putting your money into the market where it could work for you.
That’s especially true because you also get tax breaks for contributions to a 401(k) and IRA. You can make contributions with pre-tax funds to these accounts, so each contribution costs you less.
The fact you get tax advantages both for keeping student loans and for investing in retirement accounts is a strong argument that you should focus on retirement investing over student debt repayment.
Other Factors to Consider
While the math generally suggests you should put extra money into retirement accounts rather than using it to pay down student debt faster, there could be other factors to consider.
If you have substantial student loan debt, this could make it difficult for you to get other kinds of credit. Your debt-to-income ratio may be too high to buy a house, for example. Or you could end up having so much debt that it’s hard for you to qualify for parent loans to help out your own kids when they go to college.
On the other hand, if you’re worried about your health and don’t think you’ll be able to work until late in your 60s, prioritizing retirement savings could make sense to ensure you have money when you need to leave the workforce. Once you can’t work any longer, there’s no more chance to save for retirement and you must have savings to support you.
Because everyone has their own situation when it comes to their health, family, and finances, you need to look at the big picture in your life to decide what’s best.
Whether you choose to prioritize paying off student loans or focus on paying down student debt, it’s important for young adults to realize both goals are important.
You could choose to divide your spare cash up so some goes towards accomplishing each goal, or you could weigh the factors mentioned here and decide that either debt repayment or retirement savings should be your top priority worthy of all your extra cash. Whatever you decide, just make a plan and stick to it so your extra money goes to something important.
Author: Christy Rakoczy
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