You’re a successful college graduate. You made it through all of your classes and secured a job in your chosen field. You’re on your way to building a successful career and establishing your life as an adult.
Now that you’re in full-on adult mode, you’ll have to start making some pretty big decisions. What are your short-term goals? What are your long-term goals? How are your finances stacking up to help you get there?
One of the questions many young adults face is whether it’s better to pay off student loans or invest. While you might be tempted to put all your extra income immediately into your retirement fund, it’s not necessarily the winning decision when it comes to whether to pay off student loans or invest. Let’s look deeper.
Is It Better to Pay Off Student Loans or Invest?
The answer is…it’s complicated. There is no hard and fast rule when it comes to investing while juggling student loan debt. Undoubtedly, the biggest ticket item you’ll need to invest for is retirement — but whether you invest in retirement before or after paying down student debt depends on your personal preferences and situation.
The key to understanding whether it is better to invest or pay off student loans is opportunity cost. Federal student loans often have relatively low-interest rates, and if you’ve refinanced your loans, you may have secured an even lower rate.
For example, say your student loan interest rate is 4%, while the stock market has (hypothetically) yielded average returns of 15% over the last five years. Generally speaking, earning 15% interest makes more financial sense than paying down debt at 4% interest.
Investing comes with risk, but investing can be a great way to grow your money in the long run. On the other hand, paying down debt can free up additional cash flow and improve your credit score, giving you more financial flexibility in the short term.
One thing to remember: Financial tradeoff decisions don’t always have to be all-or-nothing. You might choose to split the difference by putting a little here and a little there. For example, you might contribute $300 per month to your 401(k) and $200 to a high-yield savings account for your down payment for a house, all while paying off student loans.
Things to Consider When Deciding to Pay Off Student Loans or Invest
No one, not even a financial planner, has a crystal ball and can see into the future. This is why we also need to take into account your personal preferences.
If you feel like you are truly missing out on investing in an IRA or saving for a home, then investing in those things might be the right path for you. If your student debt makes you feel burdened and miserable, you could focus on that instead.
Whatever path you decide to choose, here are some things to consider during your thought process:
1. Create a Budget and Understand Your Financial Situation
A good first step to any financial conundrum is to fully evaluate the situation. Start by gathering all of your financial documents including:
• Tax statements
• Bank statements
• Credit card statements
• Statements on student loans or other debts
Then, list out all of your monthly expenses—fixed expenses, like rent, and variable ones, like dining out.
Now, tally up all sources of income and list out your savings. After you’ve done this, you should have a pretty clear idea of how much money you’re spending, what you’re spending it on, and how that compares with the money you are bringing in every month.
Now that you have a big picture view of your spending habits, look for areas where you might be able to make changes. Take a look at any of your current subscription services with monthly payments, for example. If you’re not actively using them, maybe it’s time to cancel.
If you’re willing to call your internet or cable provider, you could try to negotiate a lower rate. After you’ve made any changes to your spending, make a new budget—one that details how much money you’re going to put toward your student loans, your savings, and your investments.
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2. Know Your Student Loan Interest Rates
Before you can decide whether to pay off student loans or save for other things, look at what you’re paying in interest for your student loans. If the rate you locked in when you took out your loan is higher than current rates, you might consider student loan refinancing. If you have multiple student loans, you could potentially consolidate and refinance them for a lower interest rate.
Of course, it’s important to keep in mind that refinancing federal student loans means you’re no longer eligible for federal benefits and protections, like income-driven repayment or loan forgiveness programs, so it makes sense to weigh the potential benefits and risks of refinancing before taking the plunge.
Opportunity Cost of Interest Rates
Comparing interest rates is an exercise in opportunity cost. Any decision to pursue one goal means you’re missing out on something else, but ideally, we look to minimize opportunity costs when assessing financial trade-offs. In this instance, the opportunity cost is leaving potential investment earnings on the table.
Let’s say you recently refinanced your student loan from 5% to 3.5%. Given the competitive rate on your newly refinanced student loan, you could consider continuing to make the monthly payment on your loan and allocating the extra cash flow elsewhere — like investing for retirement or buying a home.
Remember, we want to think about interest rates in terms of opportunity cost. What would it look like if you paid off your loan early? Your student loan costs you 3.5% annually, and that’s what you’ll “save” if you accelerate your payoff by $500 per month.
Once you paid off the loan early, you could invest your money in an asset class — such as the stock market — with the potential to earn a rate of return that’s higher than 3.5%. Historically, the stock market has returned an average of 10%. This investing can be done within a retirement account, whether a 401(k) or an IRA.
That said, stock market returns are erratic, and the annualized return figures you often hear quoted are just that — an average. Investing is risky, and there is always a chance that returns over the next five, 10, or 20 years will not outpace the interest that you are currently making on your student loan payment.
3. Other Ways to Lower Your Student Loan Payment
If you are having difficulty making monthly payments on your federal student loan due to temporary financial issues, you could consider putting your federal student loans into deferment or forbearance. Just know that while many student loans are in forbearance interest will continue to accrue, making it more expensive to pay off later.
Depending on the type of loan you have, you may be responsible for accrued interest during deferment as well. If your issues with repayment will last more than a couple of months, consider adjusting your student loan repayment plan.
If you have federal student loans, you can change your repayment plan at any time, at no cost to you. The standard repayment plan for federal student loans is a fixed monthly payment over a 10-year term. If this is too much for your current financial situation, you might consider other repayment plans.
The Extended Repayment and Graduated Repayment plans offer repayment terms over 15 or 20 years, which could make your payments more manageable on a monthly basis.
There are also income-drive repayment plans which allow you to pay a portion of your discretionary income—usually 10%, 15%, or 20%—over 20 or 25 years. These options would lower your monthly payments, meaning you would have more money to save for a rainy day or to invest. But, it’s important to note that by extending your repayment term, you will be paying more in interest over the life of the loan.
4. Pay Off High-Interest Debt
When it comes to debt, the interest rates on student loans are relatively low. While you are making monthly payments on your student loans, it could be smart to tackle any high-interest debt you may have.
Credit card annual percentage rates (APRs) average more than 16% in July 2021, which means debt can rack up quickly. If you are carrying credit card debt, you might try either the debt snowball or debt avalanche method to pay it down.
5. Build Your Emergency Fund
Now that you have a handle on your debts, it’s time to turn to your savings. The first order of business you might consider is building an emergency fund. A good goal is to have six months’ worth of expenses in a liquid account, such as a high-yield savings account. You can use this fund to cover any unexpected expenses that might occur due to a medical emergency, sudden layoff, car repairs, etc. Even starting with a small amount can help when emergency expenses pop up.
6. Save and Invest for Your Retirement
When it comes to investing for your future, one of your biggest assets is time, but it’s important to start saving as soon as possible for retirement. Even a small amount of savings can add up over time, but you may want to aim to save at least 10% to 15% of your income for retirement. To see how your retirement goals stack up, take a look at SoFi’s retirement calculator.
The best place for most investors to start saving for retirement is in a tax-favored investment account, such as a 401(k) or IRA. If you are eligible for an employer-sponsored 401(k) plan, that’s a great place to start. Some employers offer a matching contribution up to a certain percentage when you contribute to a 401(k). Take a look at your employer policy and see if you’re able to contribute enough to get the full employer match.
Another option for retirement savings is to open an IRA, or Individual Retirement Account. There are two types of IRAs: traditional or Roth IRA.
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Whether it makes sense to direct any extra cash toward debt repayment, savings or investing (or some combination of the three) will depend on your current financial situation, your short- and long-term goals, and your risk tolerance.
If investing is part of your plan, a great way to get started is with a SoFi Invest® automated investing robo-advisor. You’ll gain access to a team of financial advisors and cutting-edge automated investing technology, and we’ll work with you to determine your financial goals and risk tolerance.
Then, we’ll set up your account to meet those preferences and we’ll auto-balance your investments to keep them in line with your goals as the market changes. And anyone can invest—you can get started with as little as $5.
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Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income-Driven Repayment plans, including Income-Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.