Should I Pay Off My Student Loans or Save for Retirement

Last Updated on February 9, 2021

Student loan debt in the United States has amounted to $1.68 trillion according to educationdata.org. This large student loan debt burden has affected many young people who are looking to start families and create a life for themselves. Despite this tough obstacle, many young people still have excess savings and need to determine what to do with these savings. Should they take their savings and invest in a traditional 401(k) or use that savings to pay down their student loan debt? We’re going to share different situations all spanning 10 years that involve paying down student loan debt and investing in a traditional 401(k) plan.

Let’s say you have a taxable income of $150,000 and file taxes jointly with a spouse. Under the 2020-2021 tax brackets, your effective federal tax rate is 22%. Let’s also assume you have $70,000 of student loan debt with 10 years left at a 7% interest rate. Your monthly student loan payment would be about $812.76 assuming you’re making the same payment amount every month. What should you do? Pay down the student loan or invest in a traditional 401(k) account?

We’ll use the below numbers in several examples throughout the blog to show how different decisions may have varying financial impacts:

Income: $150,000

Effective Tax Rate: 22%

Student Loan Debt: $70,000

Monthly Payment: $812.76

Term: 10 years

Interest Rate: 7%

Considerations When choosing to Pay Off Student Loans or Invest in a 401(k)

Several factors play into the decision of whether to pay down student loans, invest in your retirement or pursue both options. Consider the various factors in order to make an informed decision, and speak with a financial advisor for more insight into your specific circumstances.

Here are a few variables to take into account when making your decision:

• The benefits of paying off student loans early: Paying off student loans early means long-term savings, as you won’t be accruing additional interest. You’ll also enjoy the peace of mind that comes with being student-debt-free.

• Interest rates on your student loans: Consider whether the interest you’re paying on your student loans is likely higher or lower than the interest you could make by investing in a retirement fund. If you’re paying a significantly higher interest rate on your student loans, it may make sense to eliminate them first, while if you’d make a higher interest rate by investing, then that may be the advantageous choice.
• The benefits of saving for retirement early: Contributions to your 401(k) aren’t considered taxable income. If investing in retirement will save you a significant sum during tax season, then it may benefit you to pursue that option. Additionally, the earlier you invest, the more time you’ll have for compound interest to help grow your funds.
• If you have federal student loans or private student loans: If you’re taking advantage of federal benefits like Public Service Loan Forgiveness (PSLF) or an Income-Driven Repayment (IDR) plan, then you may choose to focus on your 401(k). On the other hand, if you have private loans without federal benefits, then you could benefit from paying them down. Also consider refinancing private student loans for the chance of a better interest rate. 
• If being debt-free is an important personal financial goal: Being debt-free means peace of mind and the financial freedom to prioritize other things. Focusing on your student loans first could help speed up your repayment process. 
• Can student loan refinancing help you do both?: Refinancing your student loans could earn you a lower interest rate. Try ELFI’s Student Loan Refinancing Calculator* to see if refinancing could help you save enough to contribute to both student loans and a 401(k).

Scenario 1 – Paying Down Student Loan Debt Then Investing

Let’s start off by taking a look at how you can pay this debt down faster. Did you know that if you pay an extra $100 a month in addition to your regular student loan monthly payment, you’ll save $4,464.13 in interest paid? Not only will you save money by paying extra every month, but you’ll cut down the overall repayment period by a year and a half. Yes, you’ll be debt-free a year and a half earlier than you thought!

$812.76 + $100 = $912.76 Monthly Payment

After being debt-free sooner than expected, you may decide to start investing in your 401(k). If you put all of the money you were paying from your student loan into your 401(k), you’d contribute $1,094.31 monthly.

You may be wondering how you can contribute more money towards your 401(k) than your student loan payment. The answer lies in taxes.

Student loan payments are made with post-tax income. 401(k) contributions are made with pre-tax income. Since a traditional 401(k) account uses pre-tax income, you are able to contribute more towards your 401(k) than you would have your student loan debt with the same income. Though you don’t pay taxes on 401(k) contributions, ordinary income tax will be applied on 401(k) distributions.

$912.76 / (1-16.59%) = $1.094.31 Monthly Contribution

After a year and a half of contributing $1,094.31 per month, compounded monthly, at an assumed 7% rate of return, you would have $20,826.09. The investment amount of $20,826.09 combined with the student loan interest savings of $4,464.13 would give you a total 10-year net value of $25,290.23.

Scenario 2 – Investing While Paying Down Student Loan Debt

If you have a higher priority of saving for retirement than paying off your student loan debt, you may want a different option. Let’s see what would happen if you decided to put that extra $100 a month into a tax-deferred 401(k) account. The $100 would be contributed to your 401(k) account instead of your student loan debt balance, but you would continue to make monthly student loan debt payments. Due to the pre-tax nature of a 401(k), your contribution of $100 post-tax would become $119.89 pre-tax.

$100 / (1-16.59%) = $119.89 Monthly Contribution

With an assumed 7% rate of return, compounded monthly, on your 401(k), you will have approximately $20,872.19 in your 401(k) after 10 years.

Can Your 401(k) Be Garnished for Not Paying Student Loans?

If you’ve been saving for retirement, it’s likely important to you that your savings are secure. Fortunately, even if your financial situation required you to default on your student loans, your 401(k) cannot be garnished by lenders or the government.

That said, it’s important for many reasons to continue making timely student loan payments. If you fail to make your loan payment for 180 days, your loans may be put into default and you may risk having your wages garnished. Not only will this negatively impact your income, but it may also make it more difficult to continue saving for retirement. Click here to learn more about what happens if you stop paying student loans.

Scenario 3 – Employer Contributions 401(k)

Some employers will match your 401(k) contributions up to a certain percentage of your income. This could be a real game-changer. Turning down your employer’s 401(k) match is like throwing away free money. If you have student loan debt, but your employer offers a match, consider contributing to receive the maximum employer match. If you contribute $119.89 a month with an employer match while making your normal student loan payments, your money can really grow. If your employer matches the 401(k) contribution dollar for dollar, you will double your investment of $20,872.19 from Scenario 2 to $41,744.37 in your 401(k) account after 10 years.

Contributions to a traditional 401(k) are made prior to your income being taxed. The withdrawals on a traditional 401(k) are taxed. The tax rate that is applied to your withdrawals depends on your tax bracket in retirement. As the average person’s career develops, they typically continue to increase their salary and move into a higher tax bracket. Upon retirement, they will see a decrease in income and move to a lower tax bracket. This means your 401(k) withdrawals could be taxed in a lower tax bracket if done while in retirement, instead of in your working years. Note that this will only be the case if your retirement income is less than your working income.

Scenario 1 – Paying Down Then Investing

Scenario 2 – Investing While Paying Down Debt

Scenario 3 – Employer Contribution 401k

As you can see from the chart above, investing while paying down student loan debt or paying down debt then investing produces almost the same total net value. One debt payoff and investment strategy might perform better than the other depending on the return in the 401(k) account. It’s important to keep in mind that the returns on a 401(k) account are never guaranteed.

The real deciding factor on whether to invest or pay down your student loan debt will be if an employer offers employer-assisted student loan repayment. Matching contributions from your employer will make investing significantly more attractive than paying down debt. If an employer match to your 401(k) is available, it’s wise to take advantage of it.

Your comfort level with your student loan debt can be a large factor in your decision to invest in a traditional 401(k) account or to pay down debt. Knowing whether you are more interested in being debt-free or being prepared for retirement can help you make a decision. Let’s look at how student loan refinancing can help you amplify your student loan debt pay down and investment strategy.

In Scenarios 1, 2, and 3, the big question was whether you should use the additional $100 a month to pay down student loan debt or invest in a 401(k). What if you wanted to spend that $100 a month instead? Is it possible to find a way to save on student loan debt while spending that extra $100 a month? You’re in luck! This can be done with student loan refinancing.

Scenario 4 – Refinancing Student Loan Debt

By refinancing your student loan debt, you should be able to decrease the high-interest rate of your student loan. In addition, you should be able to save money over the life of the loan and in some cases monthly.

The total interest you would have to pay on your student loans of $70,000 at 7% interest over 10 years is $27,531.12. If you qualify to refinance your student loan debt to a 5% interest rate, the total interest you would pay is $19,095.03. This would mean that refinancing your student loans would be saving you $8,436.09 in interest over the life of the loan or $70.30 a month. When comparing your new 5% interest rate to your previous interest rate of 7%, not only would you be saving over the life of the loan, but reducing your monthly payment!

$8,436.09 / 120 = $70.30 Monthly Interest Savings

Learn More About Student Loan Refinancing 

Scenario 5 – Refinancing and Paying Down Debt Then Investing

Now, what happens if you refinance your student loan debt, pay down the debt, and then start investing? Refinancing your student loan debt will cut your interest rate, saving you $70.30 a month, making your monthly student loan payment now $742.46 instead of $812.76 per month. By taking the additional $100 a month and the $70.30 in student loan savings from refinancing and applying them to your monthly student loan payment, you will be debt-free two years and three months sooner than expected. Two years and three months are earlier compared to the one and a half years from Scenario 1. Just a reminder, in Scenario 1, there an additional $100 a month put towards your student loan debt. With refinancing and making the same monthly payment as Scenario 1, you will save $13,017.87 in interest over your original loan.

$742.46 + $70.30 + $100 = $912.76 Monthly Payment

Now that you’re debt-free, you can use the money that would have been used for your student loan payment to contribute to your 401(k). Since 401(k) contributions are done with pre-tax income, you will be able to contribute a pre-tax amount of $912.76, which is $1094.31.

$912.76 / (1-16.59%) = $1.094.31 Monthly Contribution

After two years and three months of contributing $1,094.31 per month, compounded monthly, at an assumed 7% rate of return, you would have $32,085.89. The investment amount of $32,085.09 combined with the student loan interest savings of $13,017.87 would give you a total 10-year net value of $45,103.76.

Scenario 6 – Refinancing and Investing While Paying Down Debt

Now let’s try refinancing while you simultaneously pay down debt and invest. In this scenario, you will cut down the interest rate on your student loan debt from 7% to 5% by refinancing. You’ll be contributing the pre-tax amount of the extra $100 a month and $70.30 a month in interest savings towards your 401(k). You will end up contributing a total of $204.17 a month to your 401(k) account.

($100 + $70.30) / (1-16.59%) = $204.17 Monthly Contribution

With an assumed 7% rate of return, compounded monthly, you will have approximately $35,544.87 in your 401(k) after 10 years. Combined with the interest savings of $8,436.09, you will have a total net value of $43,980.96.

Scenario 1 – Paying Down Then Investing

Scenario 2 – Investing While Paying Down Debt

Scenario 4 – Refinancing Student Loan Debt

Scenario 5 – Refinancing and Paying Down Debt Then Investing

Scenario 6 – Refinancing and Investing While Paying Down Debt

As you can see from the chart above, just from refinancing your student loan debt, you can save money and increase your total net value. If you take it one step further and supplement your debt paydown and investment strategy with student loan refinancing, you would approximately double your total net value! By taking advantage of the benefits of student loan refinancing, you will be able to supercharge your debt paydown and investment strategy. For those who are just trying to save money on student loans or have more money to invest in their 401(k), student loan refinancing is the way to go.

Check Out Our Guide to Student Loan Refinancing

Refinance Your Student Loans With ELFI & Start Saving

If you’re considering refinancing your student loans, you’ll want to work with a reputable lender that can support your financial needs. ELFI offers competitive interest rates, as well as the option to choose between a variable or fixed interest rate when refinancing. Additionally, you can enjoy flexible loan terms, as well as no hidden fees or prepayment penalties.

Student loan refinancing could even offer you the flexibility you need to pay down your student loans more efficiently and to contribute to other financial goals, like your 401(k). Why wait? Get started refinancing your student loans today.