Everyone knows that if they have debt they should be paying it off, and everyone knows they should be saving and investing. But which one is more important?
This week, we are looking at various kinds of debt that households have, and go through the process we use with clients on how to decide whether to put excess cash flow towards reducing debt, or increasing savings.
Today’s question is:
“Should I pay off my student loans or invest for retirement?”
For today’s episode, we are looking at the second most common type of debt in American households today, behind only mortgage debt – and that is student loans.
And for this reason student loan debt often becomes the main target for any extra cash flow in American’s budgets today.
But we find ourselves frequently telling prospects and clients to slow down on paying back their student loans, and save that extra money instead. Why?
First, student loans typically have relatively low interest rates. All federal direct undergraduate loans have been at interest rates under 6% since late 2008, with loans offered between the years 2011 and 2013 below 3 and a half percent! We compare those interest rates to historical returns investors have been able to get in the stock market, and find that historically, saving and investing has resulted in a higher return.
Just for comparison. The worst average annual return over a 15 year period since 1972 for a 70/30 asset allocation (that is 70% stocks and 30% bonds) has been 6% per year. That’s the worst. So right now, even if you have student loans at 5% and we have a repeat of the worst 15 year performance in the stock market over the last 50 years, it would still be in your interest to save and invest instead of using that extra money to pay off student loans.
Second, many federal student loans have benefits to reduce your payment if your income falls. Unlike almost any kind of debt, you can get you federal student loan payment reduced if your household income declines. These income based repayment plans offer you a form of protection against emergencies that could spell doom for those with other types of debt.
Lastly, student loan interest is tax deductible. Keep in mind that 6% interest on student loans does not cost you the same as a 6% interest on a car payment. Although this should never be your sole reason to not pay extra towards loans, it does often help tilt borrowers in favor of saving instead of paying extra.
Ultimately, we see too many recent graduates forgoing very valuable avenues to save like Roth IRAs and choosing instead to pay extra towards low interest student loans. For many, that is a mistake that will hurt your long term net worth.
Need help making the decision? Contact Us and see how we can help you.