Should You Save, Invest or Pay Off Student Loans?November 27, 2020
One of the questions many students grapple with as they begin life post-college is whether to invest or aggressively pay off their student loans. Figuring out when to start investing can be a complicated issue, especially if you’re worried about how much student loan debt you ended up with after college.
The good news is that it’s possible to start investing while paying student loans. However, everyone needs to make a decision based on their own situation and preferences. As you consider your own choices, here’s what to consider when deciding whether to start investing with student loans.
Should I Invest When I Have Student Loan Debt?
When you have student loan debt, it’s tempting to focus on paying that down—just so it isn’t hanging over your head. However, there are some good reasons to invest, even if you’re paying off student loans.
The benefits of investing include:
The earlier you invest, the longer your portfolio has time to grow. When you invest, you receive compounding returns over time. Even small amounts invested consistently can add up down the road. If you decide to wait until your student loans are paid off before you invest, you could miss out on several years of potential returns.
If you meet the requirements, a portion of your student loan interest might be tax-deductible. If you can get a tax deduction for a portion of your interest to reduce its cost to you, that could be a long-term benefit. It’s not the same as not paying interest at all, but you reduce the negative impact of the interest. For more information about the student loan interest tax deduction, speak with your tax advisor to see if you qualify.
Returns on Investment May Exceed What You Pay in Interest
The long-term average return of the S&P 500 is 9.24%. If you qualify for a tax deduction on your student loan interest, you can figure out your effective interest rate using the following formula:
Student loan interest rate x [1 – your marginal tax rate]
If you fall into the 22% marginal tax bracket and your average student loan interest rate is 6%, you could figure out your rate as follows:
6 x [1 – 0.22] = 4.68%
Long-term, the potential return you receive on your investments are likely to offset the interest you pay on your student loans.
Don’t forget, too, that if you decide to refinance your student loans, you might be able to get an even lower rate, making the math work out even more in your favor if you decide to invest.
Student Loan Forgiveness
Another reason for investing with student loans is if you plan to apply for forgiveness. If you know that you’re going to have your loans forgiven, rushing to pay them off might not make sense. Whether you’re getting partial student loan forgiveness through a state program for teachers or healthcare workers, or whether you plan to apply for Public Service Loan Forgiveness, you might be better off getting a jump on investing, rather than aggressively tackling your student debt.
A Word of Caution About Investing
While investing can be a great way to build wealth over time, it does come with risk. When paying off student loan debt, you have a guaranteed return—you get rid of that interest. With investing, you aren’t guaranteed that return. However, over time, the stock market has yet to lose. As a result, even though there are some down years, the overall market trends upward.
If you don’t have the risk tolerance for investing while you have student loans, or if you want the peace of mind that comes with paying off your debt, you might decide to tackle the student loans first and then invest later.
How to Start Investing
If you decide to start investing while paying student loans, there are some tips to keep in mind as you move forward.
Make at Least Your Minimum Payment
No matter your situation, you need to at least make your minimum payment. You don’t want your student loans to go into default. Depending on your income and situation, you might be able to use income-driven repayment to have a lower payment and then free up more money to invest. Carefully weigh the options to make sure that makes sense for your situation since income-driven repayment can result in paying interest on student loans for a longer period of time.
Decide How Much You Can Invest
Next, figure out how much you can invest. Maybe you would like to pay down your student loan debt while investing. One way to do that is to determine how much extra money you have (on top of your minimum student loan payment) each month to put toward goals like investing and paying down debt. Maybe you decide to put 70% of that toward investing and the other 30% toward paying down your student loans a little faster. There are different ways to divide it up if you still want to make progress on your student loans while investing.
Consider Retirement Accounts
If your job offers a retirement account, that can be a good place to start investing. Your investment comes with tax benefits, so it grows more efficiently over time. Plus, you can have your contributions made automatically from your paycheck, so you don’t have to think about investing each month.
Use Indexing to Start
Many beginning investors worry about how to choose the “right” stocks. One way to get around this is to focus on using index funds and index exchange-traded funds (ETFs). With an index fund or ETF, you can get exposure to a wide swath of the stock market without worrying about picking stocks. This can be one way to get started and take advantage of market growth over time. As you become more comfortable with investing, you can use other strategies to manage your portfolio.
It’s possible to start investing while paying student loans. In fact, by starting early, you might be able to grow your portfolio for the future even while you work on reducing your student loan debt. Carefully consider your situation and research your options, and then proceed in a way that makes sense for you.