For high earners, the question usually isn’t about whether or not you’ll pay off your loans (you know you will eventually). The real question is whether your extra cash is better spent paying down your loans or compounding wealth for the future. In other words, is it better to pay off student loans or invest?
This article will explore some key concepts about building wealth while paying down your student loans. However, the “right” answer for you will come down to more than just math.
The best course of action depends on factors like your personal preferences, tolerance for risk, and long-term financial goals. This is why it’s best to speak directly with a financial professional who can create a balanced plan that puts you on track to reach your goals.
Compare Interest Rates vs Investment Returns
The simplest way to approach this issue is by comparing your two factors:
- Your student loan interest rate
- Your expected investment return
In theory, you should prioritize whichever is higher.
For example, if you’re paying 5% interest on your student loans, but could earn a 6% return on an investment, you should prioritize the investment because you’ll earn an extra 1%. But if you’re paying 10% on your student loans and only expect to earn 3% on a given investment, you probably want to prioritize your loans.
That said, the choice is rarely that simple. Let’s examine how to make this decision in more detail.
Break Down How Much You’re Paying in Interest
Your student loan interest rate is the amount that you’re paying to borrow money, and average federal student loan interest rates typically range from 6% to 9%.
For example, let’s say you borrowed $50,000 to pay for your education at a 6% interest rate and a repayment period of 10 years. With a standard monthly payment, your repayment should look something like this:
- Original amount borrowed: $50,000
- Monthly payment: $555
- Total amount paid over 10 years: $66,000
- Total interest paid: $16,600
In this scenario, your student loan interest payments would add up to roughly $16,600 over 10 years in addition to the $50,000 that you originally borrowed. That said, you can reduce the amount of interest that you pay by repaying your loan more quickly.
If you were to repay the $50,000 in just 5 years (instead of 10) at a 6% interest rate, then your monthly payment would adjust to this:
- Original amount borrowed: $50,000
- Monthly payment: $966
- Total paid over 5 years: $57,998
- Total interest paid: $7,998
By repaying your loan more quickly, you would essentially cut your interest payments in half. This is a key concept to know when determining whether to pay off student loans or save.
With all this in mind, it might seem like a no-brainer to pay down your student loans as quickly as possible. However, it’s also important to prioritize investing for the future so that you can start working towards your financial goals.
Let’s explore how investment returns can factor into your financial plan.
Determining Your Investment Return
Your investment return is the amount of money that you expect to earn from a given investment. This return varies depending on the asset that you choose to invest in and the level of risk that you’re willing to take.
Here’s a breakdown of the average returns you can expect from different assets:
- The stock market (retirement accounts and investment accounts): You can expect to earn approximately 10% annually.
- Bonds: You can expect to earn between 4% and 6%.
- High-yield savings account: You can expect to earn between 3% and 5%.
- Regular savings account: You can expect to earn approximately 0.5%.
- Alternative assets: Alternative assets can help you earn superior returns, but are often more nuanced to explore. Learn more about investing in alternative assets.
Investing excess cash instead of paying down loans will typically help you build wealth more quickly.
For example, let’s say you invested $1,000/month into the stock market, which would presumably earn you 10% annually. Your approximate returns would look something like this:
- Year 1: You’d have roughly $12,640 (about $640 in gains).
- Year 5: You’d have roughly $77,171 (about $17,171 in gains).
- Year 10: You’d have roughly $201,457 (about $81,457 in gains).
By prioritizing your investments, you could build up capital that will create compound interest and help your net worth grow while you pay down your student loans. However, most assets offer much more modest returns.
If you invested $1,000/ month in a safer asset, like a high-yield savings account earning 4% annually, your returns would likely be much less impressive:
- Year 1: You’d have roughly $12,258 (about $258 in gains)
- Year 5: You’d have roughly $66,395 (about $6,395 in gains).
- Year 10: You’d have roughly $147,176 (about $27,176 in gains).
If you’re investing in an asset class that generates an attractive return, it likely makes sense to prioritize your investments. But if your asset class generates a modest return, you might be better off paying down your debt.
Again, the best course of action for you depends on more than math. This is why it’s important to speak with a financial planner who will be able to provide a much clearer answer.
Let’s examine a few of the other factors that will influence your decision to pay off student loans or invest.
Other Factors to Consider: Monthly Cash Flow
One major factor to consider is your monthly cash flow. In other words, how much money do you have coming in each month, and how does it compare to your living expenses?
If you’ve got plenty of disposable income in your monthly budget, it’s probably possible to contribute plenty of cash to both your student loans and your investments. However, if your budget is already fairly tight, you’ll likely want to be more strategic in your decision.
Your Risk Tolerance
It’s also important to consider the fact that investing involves risks and most investments do not offer a guaranteed return.
The stock market earns an average annual return of 10% based on historical data. But the market’s past performance is not an indicator of future returns. If the economy takes a turn for the worse, then the market could easily fall, bringing your net worth down with it.
If this happens, you’d not only lose money on your investment, but you’d also lose out on the opportunity to contribute more to your student loans. This is the risk you assume when you invest.
You can always mitigate your risk by investing in a less risky asset, such as a bond, treasury bill, or high-yield savings account. But the downside is that these assets typically offer lower returns.
Your Financial Goals
It’s also important to consider the financial goals you hope to achieve in the coming years and how these goals relate to your financial plan.
If you’re earlier in your career, you might opt to contribute more money towards your student loans. This gives you peace of mind, knowing you’re steadily working toward a debt-free future.
If you’re later in your career, you might choose to contribute more towards your investments so that you can build wealth as quickly as possible to buy a home, build an emergency fund, or reach other personal financial goals.
Your Time Horizon
You’ll also want to consider your time horizon, which is the length of time you plan to keep your funds invested. This can influence your decision.
For example, if you only have one year of student loan payments left, you may want to pay down your debt as soon as possible so that you can be done with it.
However, if you still have 20 years of student loan payments ahead of you, it probably makes sense to start investing now, since you don’t want to wait 20 years to start investing.
Are You Eligible For Student Loan Forgiveness?
Some federal student loans may be eligible for student loan forgiveness, which could help reduce your student debt or even eliminate it altogether.
While complete forgiveness is a bit rare, even getting your debt reduced could dramatically reduce your minimum monthly payment and make it easier to pay off your student loans early.
Contact a financial professional to learn more about existing loan forgiveness programs.
Do You Have Other Forms of Debt?
Student loans, especially federal loans, tend to have fairly low interest rates. If you have high-interest debt, like credit card debt, it might be best to prioritize paying down those balances before prioritizing your student loan repayment.
Pay Off Student Loans or Save: Which Option is Better?
At the end of the day, the “right” decision often depends less on math and more on what you want your money to do for you. Interest rates and expected returns matter, but it’s important to consider your monthly cash flow, risk tolerance, financial goals, and time horizon as well.
For many people, enjoying the peace of mind associated with being debt-free is a major life goal. If this is your mentality, then aggressively paying down your loans probably aligns best with your goals. Eliminating monthly payments can feel like lifting a weight off your shoulders and gives you the confidence to pursue other opportunities without debt hanging over you.
On the other hand, some people don’t mind having debt as long as they’re making consistent payments, and they’d rather work as hard as possible to get ahead financially. In this case, it’s probably best to direct extra money towards investments or retirement savings while making minimum payments on their loans.
The benefits of prioritizing your student loan payments include:
- Saving money on interest payments
- Improving your credit profile (by reducing your debt)
- Minimizing stress
The benefits of prioritizing your investments include:
- Making progress towards your financial goals
- Generating higher returns
- Enjoying more flexibility by building up your savings
Ultimately, your financial goals and personal preferences are the most important factors when determining whether to pay off student loans or save.
If you’re ready to create a customized plan to jumpstart your financial journey, please call ARQ Wealth at (480) 214-9572 or use our contact form to request a meeting.