Pay off Student Loans or Invest—Which is Best?

Pay Student Loans vs. Invest: Which Is Best?

For those with significant student loan debt, the idea of putting extra money towards their student loans repayments to get out of debt faster is tempting. But doing so might mean they’re unable to invest their money for long-term financial goals like buying a home or saving for retirement. So, what’s the best move? It depends on each person’s particular circumstances. Here’s what to consider:

Student Loan Interest Rates

Student loans debt has historically been called ‘good debt’ by financial experts. What does that mean? It just means that student loans often have a low-interest rate. Other forms of ‘good debt’ are things like a mortgage or a home equity line of credit (HELOC) since both have relatively low-interest rates.

These forms of ‘good debt’ are contrasted with what financial experts would call ‘bad debt’ such as credit cards or high-interest loans. Generally, financial experts will say ‘good debt’ is helpful because it allows people to finance things at reasonable rates, and that allows them to use their funds to do more important things like invest or pay off ‘bad debts.’

The question of whether or not to invest or not will depend on expected return and whether that return on investment is consistent year over . In 2019, the average rates on federal student loans was in the range of 3-5%. However, those rates have increased and many borrowers are paying as high at 8 or 9% on student debt. So the decision each year will partly come down to whether the investor believes the stock market will return more than the annual cost of their student debt.

In addition, because of the effects of compound interest, starting to save for retirement earlier will have a bigger impact on an investor’s nest egg since those funds have a longer time to grow. If an investor waits to invest until after they fully pay off their student loans, they will have to put aside more money to achieve the same amount of savings since their funds won’t have as long to grow. However, the cost of student debt also compounds. A consistent cost of 6-8% may end up being more costly than the gains on an inconsistent return that averages out to 10%, over some time horizons.

Who Holds The Loan?: Federal vs. Private Loans

Another important consideration when it comes to whether to invest or pay off student loans is who holds the loan. With Federal student loans, borrowers can forebear or defer their student loans if they’re unable to make payments because they become ill, disabled, or lose their jobs.

There are a number of repayment plans that also allow borrowers to change the amount they pay monthly. For example, the Income-Driven Repayment Plan indexes your payments to 10% or 15% of your discretionary income. Since many repayment programs also only require borrowers to make payments for 20 to 25 years, after that their outstanding balances are forgiven. While these plans reduce one’s monthly payment, interest continues to accrue, making the investor perhaps worse off than if they didn’t leverage these plans in the first place. Most advisors do not suggest these plans unless there’s a high probability the government will forgive the loan balance in the future.

Private student loans aren’t as malleable. What’s more, since student loans cannot generally be discharged in bankruptcy except under very specific extreme circumstances, that means that student loans will follow borrowers until they pay them off. For that reason, there are many benefits in terms of risk reduction to paying off private student loans instead of investing.

Another important factor is that private student loans are more likely to have higher interest rates. If a borrower is unable to refinance their private student loans and they are paying 10% or more in interest, paying down their private loan debt is the better choice.

Other High-Interest Debt

Even if a borrower has low student loan interest, that doesn’t mean that the best choice is to invest their money. If the borrower also has high-interest credit card debt, they are better off paying off that debt rather than investing since, for the same reason it makes sense to invest rather than pay off low-interest student loan debt, they will have a higher net worth after a year since they will have reduced their credit card debt.

401k Match

If a borrower’s employer offers a 401k match, the borrower is perhaps best using their funds to make a 401k contribution up to the match amount. Since the funds contributed will be matched 100% by their employer, they will immediately make a 100% profit. Note that 401k matching provisions are often not fully owned by the employee until they’ve been at the company for a specific period of time.

When To Pay Off Student Loans Before Investing

Here are some situations in which it is a better idea to pay off student loans before investing:

• A borrower’s student loan interest rate is near or over 6-7% and interest is accruing.
• A borrower is afraid of losing their ability to pay their private student loans in the future.
• A borrower who simply doesn’t want to have debt outstanding.

When To Invest While Paying Off Student Loans

Here are some situations when it is a better idea to invest before paying off student loans:

• A borrower is paying less than 5% in interest and the expected return on an investment portfolio is greater than 10%.
• A borrower’s employer is offering them a 401k match and the employee is fully vested.
• A borrower is investing in themselves and believes that the return on investment is greater than the cost of the student loan.

Bottom Line

When it comes to investing versus paying off student loans, the answer on what to do depends on a variety of factors and circumstances. Before making this decision it may be helpful to work with a financial professional.