*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation. My recommendation in this area would be Will Butler.
In the past I’ve written three separate blog posts regarding student loans. Each of those posts had a primary focus on student loan forgiveness plans and how I will be able to come out much further ahead financially by seeking forgiveness instead of aggressively paying down my student debt or pursuing the standard 10 year repayment plan. If you haven’t read those posts and are interested in the different repayment plans and student loan forgiveness, check them out. Here’s a brief summary and a link to each:
- First, I wrote about what the financial outcome would be for me comparing paying my loans off as quickly as possible vs. standard 10 year repayment vs. Pay As You Earn (PAYE). I found that I would benefit from PAYE over the other two options.
- Second, I compared PAYE to Revised Pay As You Earn (REPAYE), and I found that I will be much better off choosing REPAYE as my income driven repayment plan over PAYE.
- Third, I focused specifically on how beneficial REPAYE can be for those with high student loan debt who are also planning on reaching financial independence and retiring early.
After those posts, I was feeling like I had really driven the point home, but after many questions from readers, I discovered that many people do not trust the income driven repayment options or don’t want to utilize them and go for forgiveness. Many of the questions were from those that are specifically interested in if it makes more sense for them to quickly pay down their student debt by making extra, or larger, payments each month, or to make the minimal payment for 10 years and invest the extra money. These people want to pay off their student loans one way or another, but just want to choose the option that leads to the best long-term financial outcome. That is what I want to focus on in this post.
Does it make more sense, when on the 10 year standard repayment plan, to pay extra toward loans on top of the minimum payment, or to pay the minimum for 10 years and invest the extra money?
To best examine this, let’s use an example that would be a common situation for a new grad physical therapist.
- 25 years old
- $120,000 in debt with a 6% interest rate
- $70,000/year income
- Living in Virginia
Using the Federal Student Loan Estimator, I find that the 10 year standard repayment plan would lead to a monthly payment of $1,332/month, for a total paid over 10 years of $159,870.
Let’s assume that this individual leads a fairly frugal lifestyle, like I advocate, and that after the minimum payment and all other monthly expenses, he/she has an additional $500/month to either put extra money toward their student loans or to invest. How should he/she proceed?
The correct mathematical decision hinges on what the investment return would be if the money is invested instead of used to pay down the debt. If the annual return is higher than 6% (the student loan interest rate), then investing makes more sense. If the annual return is less than 6%, then paying down debt would make more sense. Since we don’t know the future, all we can do is make an educated guess. Since the early 1900s, the S&P 500 (an index of the 500 biggest domestic stocks, and therefore a solid predictor of the stock market as a whole) has returned an average of about 10% per year. Many people may think that 10% would be reasonable to use based on the historical returns, but since equity valuations are much higher than average, I think assuming 10% would be foolish. Somewhere between a 5-9% nominal return is much more likely in my opinion. Let’s see what the result would be if we pick the middle of that range and assume a 7% average market return over a 20 year period, while the student loan debt is at 6% interest as I said above.
Paying Down Student Debt Faster, then Beginning to Invest:
If that extra $500 is allocated toward paying down student debt, then instead of 120 months paying $1,332/month, it would only take 80 months paying $1,832/month to get rid of the debt. Just 6 years and 8 months, that’s not bad! Instead of almost $40,000 paid in interest, only about $26,500 will be paid in interest in this scenario. Once the loans are paid off, then the entire $1,832/month that was going toward loan payments can now be invested. That would mean $1,832/month invested at an average rate of return of 7% for 13 years and 4 months. At the end of 20 years, the investment balance would be $484,500 and the student loans would be long gone!
Paying Down Student Debt at Standard 10-Year Repayment, and Investing Extra Cash at the Same Time:
If the extra $500 is invested in an S&P 500 index fund earning an annualized yield of 7% from the beginning instead of being used to pay down the student loans more quickly, then at 6 years and 8 months when investments would just be getting started in the other example, this individual would already have $50,000 in an investment account and $49,000 remaining in student loan debt. With the $500/month continued to be invested up until the 10 year mark when the loans are paid off, at which point the $1,332/month will be allocated toward investments as well up to the end of the 20 year period, we end up with a total of $486,300 in the investment account. That 1% difference in interest rate leads to an extra $1,800 or so over the 20 year period!
Conclusion from this Scenario:
Mathematically, it shouldn’t be a surprise that earning an extra 1% in annualized investment return means more money at the end, but an $1,800 difference may be more than you expected. Now the question is, what do you give up for that extra 1% return? The answer is security. As I mentioned, a 7% return on your stock market investments is an estimate based on current market valuations and historic returns, and even though it is conservative, that doesn’t mean that the actual return couldn’t be lower than that amount. In this scenario, paying down the debt at 6% is a guaranteed return, while the 7% market return may or may not happen. Risk should always be considered, and $1,800 over a 20 year period may not be worth the worry that would likely come along with investing instead of paying down the debt. In this 6% debt interest rate vs. 7% investment return scenario, I’d likely go with paying off the debt over investing. That’s not the end of the story though, because there is another important factor to consider for this example.
But Wait, What About Tax Deferred Accounts?
If the individual in this scenario invested the extra $500 in a tax deferred account, such as their 401k or Traditional IRA, then that significantly changes the math. This single individual making $70,000/year is solidly in the 22% marginal tax bracket. They would also be in the 5.75% marginal tax bracket for the state of Virginia. This means that when investing $500/month in a tax deferred account, they would save $1,665 PER YEAR on their tax bill! That extra money will be allowed to compound tax-free until withdrawn in retirement, at which time taxes will be paid on the money as it is withdrawn (likely a lower tax bracket while in retirement and not working). That tax-free compounding is very valuable and significantly shifts the scales toward investing in tax deferred accounts instead of paying down student loans faster. If you’re wondering why I’m talking about a “tax deferred account” (aka a Traditional 401k/IRA instead of a Roth, here is a good example of why Traditional is better than Roth for most people).
The main two factors when considering paying down student loans versus investing are:
- Student loan interest rate compared to anticipated investment return
A 1% difference favoring investing over paying down student loan debt is probably not worth the risk, but if you’re someone with a student loan interest rate of 3-4% when a 5-9% return is likely, then it could make a lot of sense to invest.
Tax deferred retirement accounts change the game due to saving money on taxes at your marginal rate when contributing to the account. It’s hard to imagine a scenario where one wouldn’t come out ahead by taking the tax savings by investing in a tax deferred account (401k, Traditional IRA, or HSA) instead of paying down student loan debt more quickly. Everyone’s situation is different but the majority of people will be best served by deploying extra money according to this hierarchy.
- Pay down high interest rate debt: 10% interest rate or higher
- Invest in tax deferred accounts to the maximum allowed per year (ideally utilizing index funds)
- Pay down moderate interest rate debt: 6-9% interest rates
- Invest extra money in a brokerage account (ideally utilizing index funds)
- Pay down low interest rate debt: 1-5% interest rates
My opinion: Use extra money to max out your retirement accounts instead of paying down your moderate interest rate student debt to put yourself in the best position for the future and reach financial independence quicker!