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When to prioritize paying off student loans
When trying to decide what to prioritize, there are a few things you should consider:
- Your overall financial health, including what other kinds of debt you have (credit card, auto loan, personal loan, etc.)
- Your total amount of student debt and your interest rate
- Your monthly student loan payment, and how that impacts your monthly budget
- Any consumer protections you might be able to take advantage of, including federal student loan forbearance, income-based repayment plans and the possibility of federal student loan forgiveness
Then you’ll want to do a little math to see just how much interest your paying over the life of your student loan. As an example, let’s look at the average student loan balance for a 4-year public college (you can enter your own data in the FSA loan simulator to see what your monthly payments could be).
- Student loan debt amount: $26,946
- Interest rate: 3.9%
- Monthly payment: $272
- Length of loan: 10 years
If you don’t consolidate your loans to get a lower interest rate, it will take you 10 years to pay off your debt, and you’ll pay a total of $32,585 ($5,639 of which is interest payments). If you can’t afford to pay $272 a month, you could consider an income-based repayment plan, which will increase the amount you’ll pay in interest, but make your monthly payments more manageable.
But for this exercise, let’s assume that you can afford to pay the $272 each month, you already have a fully-funded emergency fund, plus you have some cash leftover. The question becomes, should you prioritize paying off your loans or investing in the market?
Next you need to think about how much you’re paying in interest. When Select spoke with Rachel Sanborn Lawrence, advisory services director and certified financial planner at Ellevest, she said borrowers should feel OK about taking on purposeful debt that’s below 10% APR, and even better if it’s below 5% APR.
If you’re paying more than 10% interest on your student loans, then you should definitely make repayment a priority (and consider refinancing). But in the case of the example above, the borrower should feel good about focusing on other priorities.
Then take the time to do the math to see how much you can earn investing your money versus paying off your student loan debt faster. Here’s an example.
Let’s say you have an extra $50 a month to put toward your loans versus investing in the market. There are a lot of calculators you can play with to see how much you could earn or save. In this case, we used the Compound Interest Calculator from Investor.gov.
- Initial investment: $50
- Monthly recurring investment: $50
- Timeline: 10 years
- Rate of return: 10%*
- Total earned over 10 years: $9,692
Now let’s look at how much you’ll save in interest if you were to put that extra $50 per month toward your student loans. For this purpose we used the Student Loan Hero prepayment calculator.
- Student loan balance: $26,946
- Interest rate: 3.9%
- Monthly payment: $322 ($272 + $50)
According to this calculator, you could save $1,072 in interest and pay off your loans 22 months faster.
While there are some savings to be had by putting extra cash toward your student loan debt, you’d earn a lot more by putting that extra money in the stock market. Plus, that money would continue to grow over time, and grow faster as time goes on because of compound interest, if you left it in the market.
Things to keep in mind
It’s easy enough to look at the math to make a decision. However, not all decisions should be made by reviewing numbers on a spreadsheet. Here are a few other things to consider when making decisions around your student loans:
- A fully funded emergency fund is the ultimate priority: Regardless of which side of the argument you choose, you should make sure to have a fully funded emergency fund with 3-6 months of expenses before you start investing or putting more than the minimum toward your loans. Before you make the decision between student loans or investing, be sure to have your emergency fund cash in a high-yield savings account. Select picked the Marcus by Goldman Sachs High Yield Online Savings as the best for its industry leading interest rates and easily accessible customer service.
- Refinancing away from public loans to private loans: If you have federal student loans and are considering refinancing, you should be wary of the trade offs. You may be able to earn a lower interest rate, but you’ll sacrifice any chances for federal student loan forgiveness through programs like Public Student Loan Forgiveness (PSLF), as well as safety nets like income-based repayment plans or forbearance.
- Having debt hanging over you can be a burden: Deprioritizing your debt to start investing for the future can be the best move on paper, but there is something to be said about the pressure of carrying a lot of debt. Capital One found that 73% of Americans rank their finances as their number-one point of stress.
- If you choose the investing route, invest smartly: Warren Buffett, one of the most successful investors and business leaders of our time, has been quoted multiple times stating that an S&P 500 index fund is a great way for any investor to make money. This index is a group of the 500 largest companies in the U.S. While there is always some risk when you invest in the market, this index has gained value in 40 of the past 50 years, with an annualized return of 10%. However, it is recommended to connect with a financial advisor to pick the right portfolio for your financial goals. Also, consider a robo-advisor like Wealthfront or Betterment.
Student loans are a drag on millions of Americans’ financial growth, and paying off that debt should always be a goal. At the same time, there will be a day when your loan amount hits zero, and there will be new financial goals to conquer. And with the power of compound interest, the one integral factor you need on your side is time.
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.