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 will help those trying to find a starting point in regards to making this critical decision. I also take it one step further for those that want to dive a little deeper.
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.
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) then the choice is easy: save, save, save. The reason is two-fold:
- When you us 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.
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.
Pay Off Student Loans Or Invest Using A Standard Repayment Plan
Let’s assume you have $100,000 in student loans with an interest rate of 6%. Also, you will be repaying this loan over 10 years. The required monthly payment would be $1,110.
Over the ten years, you will pay a total of $133,224. This figure consists of $100,000 you originally owe plus $33,224 in interest.
Let’s now assume that you have $100,000 in cash and repay your loans immediately. You no longer have student loans. Therefore, you no longer have to make a monthly payment of $1,110. Thus, you can put the $1,110 in your pocket every month. In 10 years, you would have $133,224.
In short, instead of paying your lender 6%, you paid yourself 6%. The key is the 6% 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.
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 that you are trying to decide if you should contribute $4,000 to a pre-tax retirement account, such as a 401k, or use $4,000 to make prepayments on your student loans.
If you contribute the $4,000 to your tax-free retirement account, then you have 100% of that invested since this is a pre-tax investment.
If you decide to use these $4,000 to prepay your student loans, you will have to pay taxes on the money first. If you are in the 25% federal tax bracket for instance Then you only have $3,000 to pay off your student loans.
To add to this, let’s assume your company matches your $4,000 401k contribution. This would mean you would now have $8,000 invested in your pre-tax investment instead of $3,000 to pay off your loans.
To pay off student loans or invest is a personal decision. At a minimum, I would highly suggest saving enough in your retirement account first to benefit from your company match. If you are paying off your loans and your interest rate is greater than the current risk-free rate of return on potential investments, then it makes since to pay off your loans first.
Also, if you would like to listen to a podcast on this subject, I recently joined Rachel Jermann of Talus Media to discuss. See below for the podcast: