It’s a big question for college graduates who want to get an early start on their investments but have thousands in student loans to pay off. Which choice makes the most financial sense? A little bit of number crunching can help us decide.
We should back up a bit though. A good deal of college students graduate with some amount of credit card debt. This should be the first priority. At 20-some percent, credit card debt is a monstrous plague to your financial health and should be dealt with immediately. If you’ve avoided credit card debt during your college years, kudos to you.
Now, the first thing to do is consolidate your loans. This should give you a lower overall interest rate and simplify the payback process. If you can’t for some reason consolidate all of your debt together, obviously you want to attack the highest interest rate first. A silver lining in the subject of college debt is that the interest is often tax-deductible. You will want to check on that for your personal situation and figure out how much you can save on your taxes.
If you’re consolidated student loans are at 8%, and with tax savings equals about 5%, you should consider investing versus paying off the loans sooner. The object of this game is to earn more after-tax profit with your investments than after-tax expense s of your loans. With that 5% expense on my loans, I would definitely put all the money I can in the markets and not worry about paying off the extra loan balance right now. All I would need to average is a paltry 7% gain a year or so before taxes to stay ahead, which shouldn’t be too difficult to do. It all comes down to how much you think you can earn on your investments. If your loans are charging 12%, it’s going to be tougher to beat that consistently in the market, but definitely not impossible.
One more thing to consider though. You don’t want to keep much more than a rainy day fund in low-interest savings, money market, and CD accounts. Right now, you’ll be lucky to get anything close to 5% in these bank accounts, and there are much better uses for the money, whether it’s investing or paying off loans. Well, I think that’s all for today. As always, best of luck in your journey to financial success.
2 users commented in " Invest or Pay Off Student Loans? "
Follow-up comment rss or Leave a TrackbackWhile mathematically correct, you fail to account for the risk involved in hanging on to debt instead of knocking it in the head.
Would you borrow money at 5% so that you could invest it? Most people wouldn’t. But that is essentially what you are doing if you invest your discretionary income instead of paying off your student loan.
You may disagree, and thats ok. We can still be friends
I like your site. Keep up the good work.
Jay,
I totally see your point. I’d be a pretty lousy guy to get angry and defensive when somebody expresses their disagreement with what I say.
Investing while debt interest accumulates is definitely more of a gamble than if we have no loans. If our investments do poorly, it’s a double whammy. If they do well, it’s like an extra tax sucking from our bottom line. I still like the idea of learning the ins and outs of investing firsthand, so maybe we can compromise here?
Perhaps this shouldn’t be an all or nothing decision. When investing, we diversify to try and minimize risk, so why not here? A person could split it 50/50 between investing and paying off loans. For the investing side of it, I would definitely put as much into a Roth as possible, and then the tax savings will also benefit us. That way, we are knocking off more and more of our debt each month while getting a feel for investing and putting money away for the long run.
Leave A Reply