So you are fresh out of college and you have just started your first real job. Congrats, no longer will you be forced to live off frozen pizzas, pasta, and bottom shelf beer. But, you also graduated with around $30,000 in student loans – the average student loan debt.
With your newly acquired disposable income you are probably looking to get started on saving for the future. After all, by the time you retire the average retirement age is probably going to be years past what it is today.
According to Gallup’s Economic and Personal Finance survey. The average U.S. retirement age has climbed to 61, up from 57 two decades ago, and it’s likely to age even higher. As American’s live longer the importance of financial planning at a young age becomes even more important.
If you are like most newly hired graduates you probably have some form of student debt to repay. As your period of deferment officially comes to an end, you, like many Americans, will start the task of repaying the cost of your education. This brings up a tough question.
Should You Invest or Pay Off Student Loans?
The obvious answer may be to pay down your student loan debt. Why in the world would one choose to invest before paying down debt? Isn’t the stock market volatile? Lets look at the situation a little closer. If you were lucky you received some subsidized or unsubsidized loans from the Federal Government.
If you took out a Stafford Loan you are probably paying somewhere around 4% in interest on your student loan debt. If you decided to take a Federal Perkins loan you are probably paying about 5% in interest. 4% to 5% in interest may seem rough but consider yourself lucky.
Those with private student loans find themselves currently paying upwards of 7% for most fixed rate student loans. Now lets look at the potential returns of investing your discretionary income in the stock market. The stock market is an interesting place to be, the media loves to hype the up/down moves in the market on a daily basis, but just understand that the long term trajectory of the market is up.
Sure there may be event driven volatility every few years (2008 melt down), but the market always finds a way to make new highs. The stock market on average tends to move to the upside by about 10-12% per year. Today, 10-12% in return sounds great for most of us with our savings accounts yields just 1% if we are lucky.
What looks better to you, saving 4% in student loan interest per year by paying them off early, or earning 10-12% in investment return per year? Well I would like to make the case that the 11% average early return is a better route for my discretionary income.
For example: Say you have $2,000 in extra investing/spending power. By investing that $2,000 in the broad stock market you would receive on average $220.00 in return per year. In contrast, by putting that $2,000 towards your student loan balance you would only be saving yourself about $80 in interest per year. Obviously this interest payment would increase or decrease depending on the actual rate of your student loan. You can use our student loan calculators to help you view the long-term effects of your student loans.
However, there will be some costs associated with putting your money to work. Think brokerage commissions. Today online brokers only charge investors $5 to $12 per trade. Not bad. Just google “online brokerage company”, you will find tons of offers. I generally point investors to the SPDR S&P 500 ETF. ETF just stands for “Exchange Traded Fund”. The SPDR S&P funds gives the average investor an easy vehicle to invest in the S&P500. The costs associated with this fund are very low, only about 0.1% per year. Moreover, it is by far the most actively traded S&P ETF.
Before putting all of your excess discretionary income to your student loan balance first consider the opportunity cost. Student loan interest rates on federal student loans and non-federal student loans remain very low in comparison to the returns seen in the stock market. I would advise you to strongly consider putting your investable dollars to work in higher returning asset classes. If you are young you have time to wait, stock market volatility is less of a problem. Retirement is a long ways away and the volatility will settle down over the long haul.
In the end, deciding whether to pay off student loans or invest really depends on your personal situation. Many people prefer to get rid of any debt they have before diverting their money elsewhere. If you think you can balance the costs and do both at the same time, thats great, but losing control of debt you owe can have a lot of negative effects on your financial health. Keep that in mind when making your final decision.
Author: Dave Rathmanner
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