Are you among the many students who are struggling to pay off their student loans? Are you able to repay most of your student loans now that you have enough cash? Do you wonder which investment is better?
This common investment conundrum can be solved.
Basics Student Loan
You may have student loan debt if you are like many millennial college graduates. The days of putting off the payment are long gone. You are now diligently paying off your student loan debt or investing. Let’s first review some basics about pay off student loans or invest. These are your first three debts.
- Add up the student debt that you have.
- You should be familiar with the following terms: repayment schedule (there is a range from 10 to 30 years repayment plans), interest rate, and minimum payment.
- Check with your loan provider to determine the grace period after graduation. Federal Perkins Loans have a nine-month grace period. The grace period for Stafford Loans is six months. Direct PLUS loans do not have a grace period. Repayment begins as soon as the final disbursement is received.
Loan Pay off Student Loans and Invest Factors
Let’s look at some factors that will make it easier to decide whether or not to pay off the student loans or invest somewhere. There is no right answer to financial decisions. However, understanding the aspects of the payoff or investment decision will help you chart the best course.
Loss of Liquidity
This is known as the “opportunity price” in economics. You can simultaneously decide “not” to pursue another course when you make a decision about taking an action. As an example, let’s say you have $25,000 student loan debt and $25,000 cash available to pay it off. Assume that you have at least six months’ worth of living expenses saved in an emergency fund.
Are you willing to take $25,000 to pay off your student loans debt? You won’t have $25,000 for other investments if you choose that route. Before you start to pay off your student loans debt, make sure that you understand the opportunity cost and other uses of the money like invest it somewhere.
As we continue this example, I will review the information needed to determine if you are financially better off to pay off the debt or invest the money.
Interest Rate for Debt
Your interest rate is the first thing to consider. Higher interest rates on student loans will favor debt repayment. It may be more financially advantageous to pay off student loans slowly if the interest rate is lower. You can make a better return on your investment capital if you believe you can get a higher return in the market than what you would be paying for the student loans.
What Return Can You Expect from the Financial Markets?
If the return you expect from your investments will be greater than the interest rate on the debt, it might be financially advantageous to keep the low-interest debt and invest.
It is possible to predict the interest rate of your investment, but it is difficult to predict future returns. As shown in the following table, the S&P 500’s return over the past five years has been quite varied.
How can one know what their long-term investment return is?
Although it is impossible to predict future returns on investments, historical market performance can be used as an indicator.
The S&P 500 can be used as a proxy for the performance of equity markets. The past five years have seen a phenomenal 18.2% average return. However, the average annual S&P500 return over the long term is 11.5%. (The compounded annual growth rate for that period is slightly lower at 9.8%. Historical 10-year Treasury Bond returns can be used to determine fixed income. Between 1928 and 2013, 10-year Treasury bonds yielded 4.9%. The compounded annual growth rate was slightly higher at 5.1%. However, the average annual return for investors over the past five years was just 1.5%.
Let’s say you have a portfolio of 60% stocks and 40% bonds. This will give us an easy calculation of portfolio returns. Personal Capital suggests that you include more asset classes in your portfolio. Let’s use the long-term compounded annual rate of growth for stocks (9.8%). To be more conservative, we will use the compounded year growth rate for the past 5 years (1.5%) as a bond. This gives you an expected portfolio yield of 6.5%. This may be higher than the student loan rate.
You should invest, not pay off your debt. Beyond investment returns and interest rates, there are still a few things to consider. Before I go on, I want to reaffirm what I said at the beginning of this section: It’s impossible to predict your future investments returns. However, it is possible to predict the interest rate on student loans. You could lose money if you try to make money from the spread between your loans and investments.
How can you deduct student loan interest payments?
Another reason to keep your loans is to deduct the interest that you paid on a qualified student loan. The amount you can deduct is generally the lesser of $2,500 and the actual interest paid.
Another factor that affects the ability to pay off the loans over time is the tax deduction. It may be beneficial to pay off your loans slowly if you are able to get a tax deduction every year.
The Psychological Implications of Investing Rather than Student Loans
Do you hate student loan debt? You may feel like debt is a burden on your neck and you might want to get rid of student loans.
Are you averse to risk and not able to see your investment value rise and fall? If this sounds like you, it’s time to get rid of the debt and wait until you can invest.
If the interest rate on the loans exceeds the expected investment returns, it may be worth considering investing while you pay off the debt.
No Cost to You
This decision is already complex enough. There’s another factor.
Is your employer willing to match your investment in the company 401k? If your employer matches your investment, it is a good idea to contribute enough to the company 401(k).
- Can you pay off student loans or save for retirement? What You Can Do to Both
- Do you want to take out a Parent PLUS loan or cosign a private loan?
- President Biden’s Student Loan Forgiveness Plan: All You Need To Know
- Are Joe Biden Recent Rounds Of Student Loan Forgiveness Working?
- What Happens When You Default on Your Student Loan?
- Best Ways to Avoid Student Loan: Delinquency and Default
Should I pay off student loans or invest?
It’s usually a good idea for both. Diversifying your investments is a great idea.
You can save more money for retirement if you begin saving earlier. Your money will need to grow and compound over time, making it easier to accumulate a large nest egg. If student loan debt is not a major financial burden and you are willing to put aside all other financial priorities, it is better to have a balanced approach.
There are many financial priorities to consider when you start your adult life. These include saving for a house, paying off debts, starting a family, and other important goals. It is usually more beneficial to simultaneously contribute to all your financial goals.
Prioritize higher-interest debt over low-interest debt when paying off debt. This strategy will allow you to make more money from your investments than what you pay in interest. The highest interest rate debt should be paid off first, while the lowest interest rate debt should be paid off gradually. If your projected investment return for your debt is 6.5% and your interest rate is 4.5%, you will gain 2% (6.5-5.5%) by not paying the student loan immediately.
To get an employer match, contribute at least $2,000 to a workplace retirement program. What would you do with free money? You wouldn’t, but that is exactly what you do when you don’t claim your employer contribution to your retirement plan.
Even if your employer doesn’t match your contributions, it is worth saving as soon as you can for retirement.
Make sure to have at least six months of cash reserve in case of an emergency. Because there is always something. You can also see “Pay down Debt or Invest” for a similar post. Implement FS-DAIR