Q: I graduated a few years ago with a lot of student debt. I've kept up with my payments, and thankfully now I'm starting to make more money. I'd like to get rid of my student loans faster by starting to make bigger payments, but my parents are telling me I should use the extra income to start saving for retirement. Which is the smarter move?
A: Paying off student loans early vs investing can seem like a conundrum, but look at it this way: With the choices you have presented, you can't really lose. Either one is a responsible use of your growing income.
You do still have a choice to make, and there isn't one right answer to this that fits all situations. Rather it comes down to some specific numbers. Basically, you need to investigate whether you could earn more on the money by investing it for retirement than you could save on interest by paying off your student loans sooner.
Save for retirement or pay off student debt?
Right now, the federal student loan interest rate for undergraduates is 4.45 percent. That dwarfs what savings accounts are paying these days, though it is less than the long-term expected return from the stock market. Also, you would gain a tax advantage by saving for retirement in a plan like a 401(k) or an IRA. Thus, if your interest rate is in the low-to-mid single digits, you have a good chance of coming out ahead by just making your scheduled loan payments, and putting the excess toward retirement.
Paying off student loans early vs investing
On the other hand, depending on when you got your loan or whether some of it was borrowed for graduate school, your rate might be higher than 4.45 percent, perhaps as high as 6.0 -- 7.0 percent. The higher the interest rate is, the more you should lean toward paying the debt off faster. Note that if you have multiple loans, you should target the one with the highest rate for early payment first.
Establish an emergency fund to avoid personal loans
Not to complicate things, but there is a third option you should consider. This would be to use some of your spare income to build an emergency fund. This money could be accessed at any time in case the need arises and would enable you to avoid taking out a personal loan for emergencies. These funds are typically invested in highly liquid vehicles such as savings accounts or money market accounts, and is kept outside of tax-advantaged retirement savings so you could tap into it without penalty.
Once you have built three to six months worth of expenses in your emergency savings account, you could move on to to either pay off student debt or save for retirement. Meanwhile, having that emergency savings to fall back on would give you some added flexibility to keep up with your obligations in case of a financial setback.
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