One of the most frequent questions we receive at Ellevest is what comes first, paying off student loans or saving for retirement?
For many people, taking out student loans is unavoidable when it comes to higher education. It was for me when I decided to go to grad school, but I didn’t want my student loans to define my life for years and years after graduation.
We’ve all heard stories about crippling student debt, but what you may not know is that the student debt crisis disproportionately affects women. That’s because we, on average, have a higher student debt burden than men and are more likely to have graduated from college or grad school. Once you factor in the gender pay gap, you quickly realize that we generally dedicate a large portion of our smaller paychecks to paying off student loans.
Many of us assume planning for retirement and paying off student debt are mutually exclusive, and we have to pick one or the other. The truth is it’s not that simple, and waiting to save for retirement until your loans are completely paid off may not be the best way to take control of your finances.
All About Interest
Having debt can be nerve-wracking, but remember: not all debt is created equal.
Unlike credit card debt, which should be paid off immediately, student loans can be part of a healthy financial plan — especially if you graduated from school and increased your earnings potential. Also, interest on student loans is tax-deductible up to an IRS-set limit whereas credit card debt isn’t at all.
At Ellevest, our view is that if the interest rate on your debt is less than 4%, you should consider investing in a low-cost diversified portfolio before fully paying off your loans. That’s because annually investing returns have historically exceeded that number. However, if you plan on keeping your money in a savings account (where it earns much less than 4%), you’re better off sticking to paying down your loans — even if they’re low-interest.
If you do choose to invest, a tax-advantaged retirement account like a 401(k) or IRA will enable your investments to benefit from tax-deferred compounding. This means your investments will earn returns tax-free for years until you withdraw your money. Also, investing in a 401(k) and, depending on your income level, a traditional IRA has the added benefit of reducing your income taxes.
But what if your student loan interest rates are above 4%? In that case, we’d recommend paying down your debt and lowering your interest rates through renegotiating or refinancing, though things become less cut-and-dried when a 401(k) match enters the picture.
After I graduated, I worked at a company that offered 401(k) matching. Since a match essentially puts free money into your retirement account, I decided to contribute up to the 3% limit despite one of my loans having a 7% interest rate. Those contributions meant I had less money for paying down my debt, but I believed that the match and early start on tax-deferred compounding would, over time, enable my money to work harder for me.
If you have a 401(k) match through work and an interest rate below 4%, consider saving up to the match limit. You can contribute more money if you want, but meeting that minimum ensures you get that free money. If your interest rate is above 4% but below 10% and a 401(k) match is available, we feel deciding whether or not to invest is really a matter of personal preference. Buf if your interest rate is above 10%, we suggest sticking to repaying your loans and getting a lender to lower those rates first.
Paying Down Student Loan Debt
For me, the best answer to the pay-it-off-or-invest dilemma was to do both. My reasoning was simple: investing in my 401(k) didn’t hinder my ability to work toward my goal of paying off my debt. I was still committed to paying it off as soon as possible, and I had actually started doing so while in school.
Back then, I would return any unused loan funds to the lender at the end of each semester. It wasn’t required by my loan terms, and sure, there were things I could have easily spent the money on. But it’s a loan and my mindset was that the money wasn’t mine, so it was best spent bringing down the principal — especially before my loans started accruing interest once I graduated.
If you’re out of school and have interest on your loans, you still have options when it comes to tackling your student debt:
Set your sights high
Start by figuring out which loans have the highest interest rates, and focus on paying them off first. Many people with student debt have a handful of small loans with different interest rates — I definitely did. You can find the rates online or on any paper statements from your lender.
Do more than the bare minimum
View the “minimum payment due” as a suggestion rather than a guideline. Making the minimum payment keeps your account current and pays down interest, but it doesn’t do much more than that. Bigger payments, particularly on your high-interest loans, can actually help you make a dent in the principal and save a lot of money in the long run. Be sure to tell your lender that you want the payment to be applied to the principal on a specific loan. Otherwise, the lender will apply the extra payments at its discretion.
Put extra cash & gifts toward repayment
Using bonuses for loan repayments is an easy move because by the time you receive one, you’ve made it through the whole year on take-home pay. You already know how to make things work with the money you have. I also used tax refunds, birthday money, and a small inheritance I got from my grandfather to pay down my loans.
Leaving school doesn’t mean you should leave the budget-conscious-student mindset behind. Sticking to a pared-down lifestyle now will help you pay off your loans and avoid uncomfortable adjustments later when you realize your debt and spending are too high. Once I graduated, I set a limit on how much I was willing to spend on rent in New York City and ended up sharing a room with my best friend. It wasn’t the big-city living arrangement from the movies, but I did manage to pay an extra $600 toward my loans each month while having a great time. Making concessions now — getting roommates, settling for a smaller and cheaper room, or living in a less stylish neighborhood — and following through lets you reap the benefits later.
Enroll in auto-pay
Many lenders will reduce your interest rate by 0.25% if you enroll in an automatic debit program. That may not sound like a big discount, but lowering your interest rate does save you money. Let’s say you have a private $50,000 student loan with 7.25% interest and a term length of 15 years. By the time you finish paying off the loan, you’ll have paid roughly $32,000 in interest. With a 0.25% auto-pay discount on the same loan, you’ll pay just under $31,000. Also, auto-pay makes it easier for you to stay current, which is where you have to be when trying to renegotiate your interest rate or refinance your loans.
Lower your rates
If you’re making payments by their due date — and have been for a while — see if you can get a lower rate on your loans. I used to call my lender every six months to ask for a rate reduction, pointing out that I used auto-pay, paid on-time, and, whenever possible, made more than the minimum payment. It took several attempts, but I finally succeeded in getting my rates lowered by 1%.
Student loan refinancing is another option when it comes to lowering interest. When you refinance your student loans through a bank or a site like Earnest, you replace your old loans with a new loan at a lower interest rate. The rate you’ll get depends on your financial profile, including your current income and credit history. If you’re successful in refinancing your loans, that will, in turn, free up more money for you to spend on paying down your debt more quickly. And you can also start contributing to a retirement plan.
Thanks to federal and state student loan forgiveness programs, your job may help you reduce your debt burden. These programs — which offer partial and full forgiveness over the course of several years — apply to qualifying loans for government and non-profit employees, teachers, lawyers, and doctors who meet specific criteria.
Yes, student loan debt can be daunting, but it doesn’t have to consume every aspect of your financial well-being. By gaining a detailed understanding of your debt, you can make an informed decision about when you should start investing in your retirement. And whether that happens today or after you lower those interest rates, you’ll be setting yourself up to reach one of your biggest financial goals.
The projections of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.
The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.
The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.
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