We all have limited funds at our disposal. So, using our money efficiently means making sound financial choices. Whether we’re shopping for groceries or buying a car, every dollar spent means we have less to spend in other areas.
The same goes for student loans and investing. Sarah from Colorado recently asked us this:
Hi Holly and Greg,
I started a budget a few months ago and have cut my expenses. It’s wonderful, and I’m saving more money than ever! Now, I’m trying to decide what to do next. I’m considering using the extra money to payoff [sic] my student loans early, but I’m also thinking about investing more money in retirement or mutual funds. Do you have any suggestions?
First of all, bless you Sarah! We’re freakin’ ecstatic to hear that you’re taking charge of your money. Better yet, you’re going to use that money to get even further ahead. You deserve two snaps in “Z” formation!
Seriously, good work.
Should You Pay Off Student Loans or Invest?
Now, about your question. The thing is…it depends. I’d love to offer a quick and clean answer, but there are a gazillion different factors that could influence your decision. So, before you choose whether to pay off student loans or invest that money, let’s take a look at some of the things that should drive your decision.
Why It Makes Sense to Pay Off Your Loans First
Generally speaking, I’m of the opinion that debt blows. It crushes you emotionally and financially. When you’re in debt, part of every dollar you earn is spoken for. It destroys your ability to save and it limits your options – both with your money and your career. So, yeah, I’m typically firmly in the “pay off your debt now” camp.
Shameless Plug: Holly and I just finished writing a book on this very subject. It’s called Zero Down Your Debt, and you can find it in stores now!
Beyond that, debt is dangerous. When you owe money, you put yourself in a precarious financial position. If you lose your job or aren’t able to work, there’s a good chance you won’t be able to make your payments. Student loans can be even riskier. In almost all cases, even bankruptcy won’t make them go away. That means you’ll be paying on those puppies for-ev-ah!
Finally, being in debt tends to perpetuate accumulating more debt. The fact that we already owe dulls our senses to the harm that debt causes. But when you’re out of debt, the last thing in the world you want is to rack up a new payment. Paying off your student loans quickly helps you enter that state of mind in a jiff!
Why It Makes Sense to Invest First
Although I abhor debt, there is an argument to be made for investing the extra money you’re saving. Depending on the type of loans you have and their interest rates, keeping your loans and investing your money may be the correct mathematical solution. By paying your loans off early, you could be losing money to opportunity cost.
So what is opportunity cost? Let’s look at an example to understand the concept. Suppose you keep $10,000 in a savings account. That’s fine and dandy, but you could be missing the chance to make additional money by investing it in the stock market instead. The loss of potential gain is called opportunity cost.
By paying off your loans instead of investing, you could be missing out on the chance to make more in investment returns than you save in interest payments. The basic rule is this: If your interest rate is lower than your potential market gains, you should keep the loan and invest the rest. Mathematically, you’ll come out ahead…provided you actually invest your savings.
Digging Into the Numbers
So, let’s get a little more specific. We’re going to create a few examples which make some assumptions. Then, we’ll use LendEdu’s nifty new student loan calculators to run the numbers. Because “average market returns” are a bit misleading, we’ll use the Compound Annual Growth Rate (CAGR) over the last 60 years – which is roughly 6% – to calculate our expected investment gains.
Assumptions: Federal Direct Subsidized Loan: 3.4% Interest Rate, Loan Amount: $35,000, Loan Term: 10 years, Extra Payment: $200/month, Market CAGR: 6%, Investments are tax deferred
Paying Off Student Loan Early: According to the student loan prepayment calendar, our monthly payment on this loan would be about $345 per month. By paying an additional $200 a month, we would save $2,700 in interest over the life of the loan. We’d also pay the loan off 5 years and 11 months early. Not bad, right?
Investing the Extra Money: Using the “Student Loan Payoff vs. Invest” calculator, we find that paying off our loan early isn’t the correct mathematical choice. By investing that extra payment at a 6% return over the same time frame, we’d come out an additional $1,612 ahead. In this case, it is mathematically correct to invest the extra money rather than pay off our student loans early.
Assumptions: Federal Direct PLUS Loan: 7.9% Interest Rate, Loan Amount: $35,000, Loan Term: 10 years, Extra Payment: $200/month, Market CAGR: 6%, Investments are tax deferred
Pay Off Student Loan Early: In this case, the calculator figures our monthly payment to be $423 per month. If we use the same $550 payment, we’ll still save $3,685 over the life of the loan and knock 2 years off of our term. However, if we keep our extra payment at $200/month, we’ll save a whopping $6,941, paying it off in just under 6 years. That’s a big chunk of change!
Invest the Extra Money: By investing the extra $200 instead of paying off our student loans early, we’ll actually lose out on $3,604. Even if we use the same $550 payment, we still save $1,971 by paying the loan off early. In this case, since the interest rate on the loan is higher than our expected return, we’ll save a lot more by paying off the loan early.
As you can see, when the interest rate on your loan is lower than your expected investment returns, the math dictates that investing supersedes any gains you’d get by paying your loan off early. If your interest rate is higher than any investment returns you can reasonably expect, paying your loans off early is the correct mathematical choice.
However, there’s more to it than just the numbers because numbers can be tricky. Basing investment return assumptions over a long period of time may not accurately predict what the market will do in the short-term. Yes, the average return may be 6% over the last 60 years, but student loan terms generally last only 5 to 10 years. That’s a very short investment window to play with. The market can swing wildly over such a short period, which could be good or bad for you. Often, the market falls short of the average annual mark, while other times it goes far above. Over the course of decades, those swings even out. Over a shorter period, they may not.
Benefits available on certain federal loans, investment advisor fees, and your emotional attitude toward debt also must be considered. Plus, you actually need to use that extra money for investing – which is something many people actually fail to do. Spending the extra money on consumer goods doesn’t help you save on either front.
In my opinion, it’s never a bad idea to pay off debt. Although you might miss some investment gains, there is no doubt that you’ll save money. Better yet, you don’t have to guess how much you’ll save. Just use a student loan prepayment calculator and you’ll be able to see the concrete, real results that paying early will have.
Of course, there’s no reason you can’t do both. Pay some toward your loans and invest the rest. Doing both is just another way to diversify your financial plan.
What do you think? Do you prefer to play the numbers or would you rather go for the sure win? Let us know in the comments below.