• College Planning

Should I Pay Off My Student Loans Or Invest?

August 11, 2014 | Barbara Friedberg

Are you one of the thousands of workers in the throes of paying off your student loans? Do you have the cash to pay off most of the debt now? Are you wondering which is the best use of your capital, pay off the loans or invest in the financial markets?

Learn about how to reconcile this common investing conundrum.

Student Loan Basics

If you’re like many millennial college grads, you amassed a few dollars in student loan debt. And the postponement of the payoff is a distant memory. Now, you’re conscientiously paying off the debt. Before we get into whether you should bite the bullet and zap the debt all at once, let’s review a few student loan basics. Here’s are you first three debts:

  1. Tally up how much student loan debt you have.
  2. Familiarize yourself with the important terms: repayment schedule (there are a range of repayment plans from 10 to 30 years), interest rate and minimum payment.
  3. Confirm what the grace period upon graduation is, which depends upon the type of loan. Federal Perkins Loans offer a juicy grace period of nine months. The Stafford Loans offer a six month grace period. The Direct PLUS loans have no grace period and repayment begins upon receipt of the final disbursement.

student loan payment interest rates

Loan Payoff Factors

Before deciding whether to pay off the loans or not, let’s examine some issues which will help make the decision easier. Like many financial decisions, there’s no “right” answer for all, but understanding the facets of the payoff versus invest decision, makes it easier to chart the course that’s right for you.

Loss of Liquidity

In economics this is referred to as the “opportunity cost”. Whenever you make a decision to take an action, you are simultaneously deciding “not” to take another course. Thus, assume that you have $25,000 in student loan debt, and $25,000 available cash to pay off the debt. Further assume that you have an additional amount saved of at least six months of living expenses in an emergency fund.

Do you take the $25,000 and pay off the debt? If you go that route, then that $25,000 is not available for alternative investments. Before grabbing your checkbook and paying off the debt, understand the “opportunity cost” or other uses for that money.

As we continue with this example, I’ll review the information you need to decide whether you are better off financially to zap the debt or to invest the money.

Interest Rate on the Debt

The first factor to consider is your interest rate. The higher the interest rate on the student loans, the more the scale tips in favor of paying off the debt. If the interest rate on the loans is lower, it may be financially beneficial to pay off the student loans more slowly. If you think you can earn a greater return in the markets than the interest you are would be paying off on the debt and invest the capital in the financial markets.

What Return Do You Expect in the Financial Markets?

If you expect the return on your investments to be higher than the interest rates on the debt, then it may be financially beneficial to hang on to the low interest rate debt and invest.

While you can predict with certainty what your interest rate is going to be, predicting the future returns on your investments is not as easy. The return on the S&P 500 during the past five years has varied meaningfully, as shown in the table below:

Historical Market Returns

 

So how does one determine what their long term investment return will be?

While it’s impossible to predict your future investment returns, we can at historical market performance as an indicator.

We can look at the S&P 500 as a proxy for equity market performance. While the past five years have shown a fantastic 18.2% average return, the average annual S&P 500 return over the long-term was 11.5% (the compounded annual growth rate over that time period is slightly less, at 9.8%). For fixed income, we can look at historical 10-year Treasury Bond returns. From 1928 to 2013, 10 year Treasury bonds returned 4.9% (the compounded annual growth rate is slightly more, at 5.1%). But the last five years gave investors a subpar 1.5% average annual return.

For a simple portfolio return calculation, let’s assume you’ve got a portfolio that is 60% stock and 40% bonds. (Note: Personal Capital recommends including more asset classes in your portfolio). For stocks, let’s use the long-term compounded annual growth rate of the S&P 500 (9.8%). For bonds, let’s use the compounded annual growth rate of the last 5 years (1.5%) to be more conservative. That gives you an expected portfolio return of 6.5%. That may be higher than your student loan rate.

So should you invest instead of paying off your debt? There are a few factors left to review besides investment returns versus interest rate. But before I continue, let me pause first by repeating what I began this section by saying: it’s impossible to predict your future investment returns. Your student loan interest rate, on the other hand, is possible to predict. By trying to earn money on the spread between your investments and your loans, you risk losing money.

Can You Deduct the Student Loan Interest Payments?

One other reason to keep your loans around is that you may be able to deduct interest you pay on a qualified student loan. Generally, the amount you may deduct is the lesser of $2,500 or the amount of interest you actually paid.

This is another factor in the paying the loans off over time column. If you can get a tax deduction each year, it may be beneficial to pay your loans off more slowly.

Psychological Considerations of Paying off Student Loans Versus Investing

Are you one who abhors debt and will always feel uneasy with student loan debt? If you feel that debt is a weight around your neck, then you may want to pay off the student loans to be free of the debt.

Are you risk averse and ill-suited to watch your investment value go up and down? If that sounds like you, then that’s another reason to get rid of the debt and wait to invest.

On the other hand, if you’re comfortable watching your investment portfolio value go up and down, and interested in maximizing your potential financial gain, in spite of the risks in investing, then investing while paying off the debt, may be a better alternative if the interest rate on the loans is lower than the projected investment returns.

Free Money Consideration

As if this decision wasn’t already complicated enough, there’s one more factor to consider.

Does your employer match your investment into the company 401(k)? If so, then in most cases, you are well advised to contribute enough to the 401(k) to get the employers contribution.

Should I Pay Off Student Loans or Invest?

In most cases, it’s a good idea to do both. It’s generally always a good idea to diversify your investments.

The earlier you start saving for retirement, the more time your money will have to grow and compound, and the easier it is to build up a substantial nest egg. Unless the student loan debt is ruining your psychological life and you are willing to put most other financial priorities on hold, then it’s preferable to take a more balanced approach.

In the beginning stage of your adult life, there are a myriad of possible financial priorities; saving for a home, paying off debt, starting a family, and more. It’s usually better to simultaneous contribute to all of your financial goals.

When paying off any debt, prioritize higher interest debt over debt with a low interest rate. The strategy is to earn more money on your investments than you are paying in interest. Pay off the highest interest rate debt the most aggressively, and the lower interest rate debt more slowly. For example, if your projected investment return is 6.5% and the interest on your debt is 4.5%, then you are gaining 2% (6.5%-4.5% by not paying off the student loan right away).

Contribute at least enough to a workplace retirement plan to get an employer match. Would you turn down free money? Of course not, yet that is what you are doing when you don’t claim the employer contribution into your retirement plan.

Even if you don’t get an employer match, you may want to consider saving for retirement as soon as possible.

Finally, make sure you have at least a 6 month cash cushion for the unexpected. Because something always comes up. For a related post, please see, “Pay Down Debt Or Invest? Implement FS-DAIR“.

Photo Credit: Convocation at W&M by Stephen Salpukas

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