By Joseph Reinke, CFA, CEO of FitBUX
One of the most common questions we get at FitBUX is “Should I pay off student loans or invest?” This is a complex question because each person’s goals are different and both options have advantages as well as disadvantages.
This article discusses 7 steps you need to take in regards to making this critical decision. The first steps 5 steps are for those looking to keep it simple. The last two are for those want to take their plan to a more “advanced” level.
I want to emphasize one point. This article is written from a “money efficiency” standpoint. Therefore, I am referring to the approach that is beneficial in the long run purely from a math standpoint. At the end of the day, the best choice is the one you understand, are comfortable with, and will implement.
You may also listen to our podcast on this topic below or watch the video above:
Table Of Contents:
- First & Foremost: The Right Mindset
- Pay Off Student Loans Or Invest: The Starting Point
- Understanding Risk Vs Return
- Get your Employer Match
- Pay Off Student Loans Or Invest In After-Tax Accounts
- What Happens Over Time?
- Not All Investments Have The Same Risk & Return
- Advanced Topic 1: Not All Money Is Treated Equally
- Advanced Topic 2: What About Buying A House Vs Paying Off Student Loans?
- Advanced Topic 3: What About Starting A Business Instead Of Paying Off Student Loans?
First & Foremost: The Right Mindset
There is this saying out there, “Invest early and often to take advantage of compounding interest.” This is great…unless you have debt.
You see, when you collect interest on an investment it means that YOU are lending money to someone else and they are paying you interest on it.
When you borrow money YOU are the one paying interest, i.e. you are essentially helping someone else compound interest.
You have to understand this relationship to answer the question: Should I pay off student loans or invest. Its not as simple as “Invest early and often to take advantage of compounding interest.”
When deciding if you should pay off student loans or invest, you have to look at the net effect of how much money is going out of your pocket vs how much money is coming into your pocket.
Pay Off Student Loans or Invest: The Starting Point
We need a starting point when deciding to pay off student loans or invest. The first place to start is determining what student loan repayment plan you are going to be using.
If you will be using an Income-Driven Repayment plan (IDR, REPAYE, PAYE, IBR, PSLF) then the choice is easy: save, save, save. The reason is two-fold:
- When you use and IDR plan, you are going for loan forgiveness. Thus, there is no point in paying back something that will end up being forgiven anyway.
- The amount forgiven will be treated (and taxed) like regular income, so you should be saving all you can to make sure that you can cover this future tax liability.
As a general rule of thumb, when I see a FitBUX Member have a total debt to income ratio of about 2.25x then financially it starts to make more since to use IDR. This means for example, if I make $78,000 per year and I owe over $180,000 it could make since to go with an income driven repayment plan.
However, there is a lot that can complicate that decision:
- Do you want debt for 20 – 25 years?
- Are you getting married and what is your spouses’ income and Federal loan debt look like?
- What are the tax rates going to be on forgiveness in 20 – 25 years?
- If you have to save for the tax, combined between saving and your monthly payment, is IDR really saving you anything?
- What are your other goals, i.e. buying a house, etc…
For everyone, the answers to these questions are highly personalized. We have free tools and Coaches for FitBUX Members that help you personalize this decision and I highly recommend you take advantage of it so you don’t make the wrong decision.
Deciding to pay off student loans or invest gets a little more complicated if you are repaying your student loans using a standard repayment plan. The key in this situation is looking at the interest rate on your loans.
Understanding Risk Vs Return
The appropriate way to decide if you should pay off your student loans or invest is to understand the most important element of your finances: Risk vs. Return.
The first aspect of risk vs return you need to examine is from the investment stand point. People say invest early to compound interest….but what are you investing into? All investments have different levels of risk.
The second aspect of risk vs return is on the debt side and this is often overlooked in finance, i.e. more people only concentrate on investment risk and return. When you have debt, you have more risk…but why?
When you have debt you have an added expense every month. This means that your budget has less flexibility. This risk can materialize at really bad times. For example, what if COVID hits and you lose your job? The more debt you have the more risk you have of being in financial trouble.
I’m not going to dive to deep into risk vs return in this article. However, if you want to learn more about it, check out our podcast titled Manage Your Risk & Your Return Will Be There.
Get Your Employer Match
If your employer offers you a retirement plan that has a match, I highly suggest you take advantage of it. Let’s look at why from a risk vs return perspective.
Let’s assume you make $70,000 a year and your employer offers a 3% 401k match. This means if you put $2,100 a year into your 401k the company will put in $2,100 a year. THAT IS A 100% RETURN WITH ZERO RISK. That is probably the best one year investment you’ll ever make in your life. It’s definitely better than the 5.8% you are paying on your student loans.
(Note: You’ll understand why the 5.8% is important in the next section. Also, 5.8% is not a random number. That is the average interest rate of FitBUX Members managing over $1 billion of student loans on FitBUX.)
Even if you company only matches your contribution by 50%, that is still the best one year invest you’ll probably ever make.
Before we proceed, I mentioned earlier this analysis is purely from a mathematical standpoint. Some of you may decide that you’d rather pay off your loans instead of investing into your 401k and forgo your match. That is fine…I’d rather have you do what fits your personal goals if that is what you are comfortable with. However, I highly suggest getting your employer match.
Pay Off Student Loans Or Invest In After-Tax Accounts
In the section above, we discussed get your employer match. In this section, we are going to compare paying off your student loans or investing in after-tax investment account such as Roth IRAs or brokerage accounts.
Let’s assume you have $120,000 in student loans with an interest rate of 5.8%. Now I’m going to do something extreme. Let’s say you inherited $120,000 and I paid off my loans tomorrow. That means you don’t have to pay 5.8% anymore, i.e. every month that goes by, instead of giving that to your lender, you can put it into your pocket.
In short, instead of paying your lender 5.8%, you paid yourself 5.8%. The key is the 5.8% you put back in your pocket is risk-free. Risk-free means the money wasn’t invested and exposed to any kind of financial loss.
Therefore, when deciding to pay off student loans or invest, you have to look at the risk-free return on investments such as savings account, certificate of deposit, and treasury bonds.
If those investments return less than the interest rate on your student loans, then, purely from a financial perspective, it makes more sense to repay your loans rather than invest.
What Happens Over Time?
In the above section, we assumed that you inherited money and paid off your loans immediately. However, most of us can’t repay our loans with a snap of our fingers. We have to pay it off over time. So lets’ look at that example.
Using the same figures above of 120k in student loans at a 5.85% interest rate I’m going to compare two scenarios:
Scenario 1: Pay off loans aggressively then save afterward
In the first scenario I pay off my loans aggressively. I’m assuming that I make 73k per year in salary and I’m going to put 27% of that towards my loans. Therefore, I am going to pay $1,642.50 per month towards my loans. After my loans are paid off, I’m going to take that money and invest it at the risk free rate of 1.5%….How much money would I have after 20 years?
Scenario 2: Pay Off My Loans Slowly & Invest
In this scenario I am only going to make the minimal required payment over 20 years which is $845.93 per month. Then I’m going to take $796.57 each month and invest it at 1.5% ($1,642.50 – $796.57). How much money do I have after 20 years?
Paying Off Student Loans vs Investing Results
In scenario 1 I’d end up $270,000… Scenario 2, I’d have only $223,000 after 20 years. Therefore, it makes financial since, from a risk-return perspective, to pay off my student loans first then invest afterwards vs investing today and slowly paying off my student loans.
Not All Investments Have The Same Risk & Return
This leads to one of my favorite topics and where we start diving into more of the “advanced” financial discussion. Whenever I do a student loan workshop and go through the information above, there is always someone that raises their hand and asks, “well what about investing in the stock market? The stock market yields10% per year. Plus the stock market is long-term so there really isn’t any risk!”
The person asking the question is right…partially. The part they are wrong about is the 10% yields per year return (Especially the myth about compound interest and yield). I am going to discuss two fallacies first then go through two scenarios for examples.
People quote average returns from studies but don’t really understand what they are looking at. So instead of looking at studies, I looked at real stock market returns (using the S&P 500), since January 2000 through January 2020. The average the S&P did during that time span was about 3.3%. During that same time period, the S&P paid dividends at about 1.9%. For the sake of simplicity, add 3.3% and 1.9% and you come out to about a 5.2% average return for the past 20 years.
If you invested in the stock market you could expect a return of about 5.2% annually over the past 20 years. However, most people believe in the theory of diversification. In short, actual people managing money DON’T PUT 100% OF THEIR MONEY IN THE STOCK MARKET. Therefore, the actual returns you would expect is less than 5.2%!!!!
So lets’ run some scenarios of paying of your loans vs investing in the stock market:
We are going to use the same assumptions as the previous scenarios above. However, instead of investing in the risk-free rate after we pay off our student loans, we are going to invest 100% of our money into the stock market.
Results Of Paying Off Your Loans Vs Investing In The Stock Market
Scenario 1 (paying off your loans then investing afterwards: $573,000.
Scenario 2 (Making minimum payments for 20 years and investing in the stock market): $548,000
Thus, over the last 20 years, if I had student loans, I would’ve been better off over the long run paying them off then investing afterwards….and that includes if I were investing in the stock market! Not only that but because I paid off my loans, I have less risk to my overall personal financial profile! For those of you that are already FitBUX Members, your FitBUX Score, would increase faster and in the long run would also be higher.
Advanced Topic 1: Not All Money Is Treated Equally
To keep things “interesting”, pre-tax retirement accounts throw a wrench in the above thought process.
Let’s assume you already got your 401k match. You can still contribute to your 401k on a pre-tax basis. Let’s assume you have an effective tax bracket of 8.2%. In short, this is like an 8.2% return on my money. If my loans are at 5.3% and my effective tax rate is 8.2%, then from a financial perspective it makes since to max out my 401k before paying off my student loans. But….let’s look at the numbers from a risk vs return perspective…
Using the same assumption we used in the previous examples above, I’d have about $40,000 more in scenario 2 relative to scenario 1, i.e. I’d have 40k more if I contributed to my 401k relative to paying off my student loans aggressively. However, there are two things to consider.
First, over 20 years, is an extra 40k worth it or would I rather be debt free? In short, you have to say is 40k extra worth the increase in risk to my overall financial profile…again it boils down to risk vs return!
Advanced Topic 2: What About Buying A House vs Paying Off Student Loans?
I get asked all the time, should I buy a house first then pay off my student loans or vice-versa.
There are two ways people look at this. One way is the wrong the other is correct.
The first way (which is wrong) is when people say to buy the house first because its an investment. This is the wrong way to look at it because real estate is actually a really bad investment. Average appreciation is about 3%….then you have to factor in costs such as mortgage interest, upkeep, property taxes, insurance, and the list goes on.
The second way (which is the correct way to look at it) you have to look at different financial aspects such as what am I paying in rent vs what can I buy a house for? Then you have to factor in the costs of owning a house. What is the actual return that I’m getting vs the risk I’m taking. For risk, you also now have to include the mortgage debt as risk to your personal financial profile as well.
This is an extremely complex calculation. However, we have good news for you. Around July, 2021 we will be launching a new technology at FitBUX were you can compare this exact scenario based on your personal situation…so stay tuned for that announcement and check back often.
Advanced Topic 3: What About Starting A Business Instead Of Paying Off Student Loans?
This question is a much bigger beast to answer. My recommendation is to no longer think of your debt as student loans. Instead, you must think of it like a business loan.
Some business owners will tell you never to start a business with debt. However, in my personal opinion it doesn’t matter as long as you understand the debt that you have and you believe the risk of having that debt is outweighed by the potential return of starting your own business.