Pay off student loans or invest — how to move toward funding retirement


In my recent post, “Why investing can be better than paying down debt,” Dianecy's comment raised a question faced by many: What do you do about investing when you have student loans?

It is quite the dilemma, actually, because the best time to start funding your retirement is when you're still in your 20s. And as anyone who has been reading Get Rich Slowly for more than, say, 10 seconds would know, few things impede your progress toward getting rich (at any speed) like debt.

The reason is simple: A dollar can be spent only once — either for another person's benefit or for yours. So it follows that repaying debt benefits the bank; investing those same dollars in a CD or index fund, on the other hand, benefits you and your future.

Therefore, debt avoidance is always the best strategy. It may not always be easy, but it is almost always possible. Many have figured out how to get an education without incurring student debt. I managed to fund my bachelor's, master's and doctoral programs without getting into debt. It's like the old maxim: “Where there is a will, there is a way.”

Not inevitable, but a big problem nonetheless

So student debt, therefore, is not inevitable. However, not everyone gets the memo in time, and you may find yourself with some student loans. You are not alone. This New York Fed chart shows the meteoric rise of student debt in the U.S. and how it now dwarfs other forms of debt:

student debt 2014

You can see how student debt went from the smallest category of non-mortgage consumer debt to the largest — in less than 10 years. But the size of the problem isn't the only issue. Concern at a national level over student debt cutting economic growth off at the knees prompted the study from which that chart is taken.

How student debt strangles the economy

It is somewhat of a chicken-and-egg situation: Student debt payments put a drag on young people's ability to strike out on their own and buy their own homes — two of the prime factors that drive any economy.

This hampering of household formation (in economics-speak) makes for a slow recovery, in turn creating a vicious cycle of low growth which means fewer opportunities, prompting more people to get a degree in order to do better in a weak economy. That, of course, adds to student debt, and the vicious cycle continues.

Moving forward despite the difficulties

What's true from 30,000 feet is true on the ground: Paying back student debt can put a crimp in anyone's ability to get on their feet and move ahead financially.

There are two reasons student debt is not as easy to dismiss with the blanket pay-all-debt mantra as, for instance, car loans and credit card debt. The first reason is the interest on a student loan is typically lower than all forms of debt save for home mortgages. The second is a little more complex.

Fixed vs. variable cost — the move

If it wasn't for one single factor, debt could have been a wonderful thing. What factor is that? Inflexibility. When tough times come (and they come to most of us a few times in our lives), you can adapt by cutting your costs. You can move to a cheaper place, even move in with family. You can eat for less, stop buying new clothes, drive less, and so forth.

The one thing you can't cut, though, is debt payments. That's the problem, and it gets worse when you live a lifestyle which leaves little margin for error. Accountants call those inflexible payments “fixed costs” — costs you can't change when things go bad. The costs you can change (food, gas, clothing,etc.) are called “variable costs.”

Your ability to ride out bad times improves, therefore, when you have few or no fixed costs. Now, if you were able to convert a fixed monthly payment into a variable payment, the greatest risk of that debt would be mostly mitigated.

And with most student debt, you do have that option. According to the Federal Student Aid office of the U.S. Department of Education, most student loans are eligible for one of the following three types of income-driven repayment plans:

  • Income-Based Repayment Plan (IBR Plan)
  • Pay As You Earn Repayment Plan (Pay As You Earn Plan)
  • Income-Contingent Repayment Plan (ICR Plan)

None of them require utilizing more than 20 percent of your disposable income. If you were to sign up for one of those plans, your repayments would become a variable cost, instead of a fixed cost.

If you can do that, your decision to repay the debt or invest becomes a mathematical decision. If you can earn more on your investments than you pay in interest on your student loans, then it makes sense to keep your student loan repayments to the minimum and invest up to your annual maximum in your IRA and 401(k) or equivalent employer retirement plan.

However, that doesn't work for everybody.

Giving weight to uncertainty

As one of the commenters to the previous post pointed out, you have a great degree of certainty in predicting your debt payments but almost none when it comes to the returns on your investments. He pointed out (correctly) that, when we present the benefit of investing in the future, the chart inevitably has an elegant linear look to it. In truth, however, we don't know how things will play out in the future — it can be better or it can be worse — but we can be pretty sure it will not be like in the chart.

The problem is that investing returns come in fits and spurts. The cornerstone of most everyone's investments are stocks. The overwhelming majority of mutual funds (especially index funds) are based on stock investing. The stock market, therefore, is the largest driver of personal wealth in America today (excluding owned residences).

And if there is one thing we know about the stock market, it's that it goes up and down, as this inflation-adjusted chart of the Dow Jones Industrial Average clearly shows:

dow 1920-2015
Dow Jones Industrial Average since 1920. (Source: macrotrends.net)

We love those ups, don't we? These past few years the stock market has made double-digit gains every year. Problem is that nobody can predict when those pesky downs will come and wipe out most of those gains. (If we could, we would all be millionaires.)

Be aware of manipulating uncertainty

That's the bad news. The good news is that, for the past hundred years, through the cycles, the stock market has gone up more than it has gone down, as the dotted red arrows show in the Dow chart above. Cycles typically last 10 years or less (top to top or bottom to bottom). Therefore, if you are in the market for more than, say, 20 years or so, the ups and downs average themselves out and you are left with the long-term uptrend.

As you can see, no two cycles in the past were identical, and it is impossible to guess what the future will hold. After all the ups and downs, the market grew roughly at 8 to 9 percent per year.

(Note: If you pick a start date at a top and an end date at a bottom, the number will look a lot worse; and if you pick a start near a bottom and an end near a top, it will look much better.) That's why most people use a simple projection of 8 to 9 percent per year, even though we know any given year will be way different from that average.

However, we have no guarantee of even that average. Therefore:

  • You typically know exactly what benefit you will derive from repaying your student debt.
  • On the other hand, you can't predict exactly what you will receive when you invest. All you can hope for is some historical average.

Temperament and uncertainty

This is where your temperament comes into play as you weight the uncertainty:

  • If you're a conservative pessimist by nature, you will feel much more comfortable if you prioritize repaying your student debt and removing as much uncertainty as possible.
  • However, if you're an optimist with faith in the future and some tolerance for risk, you will feel more comfortable (excited, even) keeping the student debt payments to a minimum and pushing hard to maximize your retirement investments.

You can make either strategy work for you — there is no single one-answer-fits-all solution to the problem of repaying student loans and investing for your retirement (other, of course, than to avoid getting into debt in the fist place, which naturally frees up that much more to invest for retirement).

Avoiding debt — two practical suggestions

1. The CD ladder

In another of the comments to the previous post, Diva mentioned something which bears repeating and expanding upon:

“When I was in school, a wonderful banker had me break up my loan into monthly portions, and then each portion was set into a CD that would come due every month. That way I stayed on budget and, while the interest was low, came out of it with some grocery money. Every month I started fresh with a new influx of cash, and always had enough until the next loan period.”

In other words, her banker fashioned a CD ladder for her. This is a great strategy when you receive the proceeds of a student loan in a lump sum. By parceling it into multiple CDs with staggered maturities, you get a steady flow of income every month to match your running expenses, and you are freed from any temptation to dip into the loan and leave yourself short later on.

2. Never invest loan proceeds

A few people discussed another bit of practical wisdom pertaining to student debt that bears repeating: Don't be tempted to invest your loan proceeds when you receive them. Investing normally has a longer time horizon than your studies. With a long-term view, you can ride out short-term dips in the market — but you can't do that if you need the money to pay expenses in, say, two years. It's much better to keep the proceeds in something liquid but safe like a savings account or a group of laddered certificates of deposit.

Keep moving to fund your retirement

Of course, the best of all worlds is never to have debt and, if you do, then to kill it while still investing. The best of all worlds is also me having Warren Buffett's money and Robert Redford's looks — nice, but not most people's reality.

Most of our financial pictures have, shall we say, imperfections; but no two people have the same set. The key to success is not to think of the past, but to look to the future and figure out the best thing going forward, given the situation at hand.

Regardless of what others might say (or want to hear), there is no one strategy which works every time. For some, applying their discretionary cash to investing works best; for others, using it to pay down student debt works better. Either way can work if you stay at it diligently.

What works for you — paying off your student loans first or investing while paying student loans? How did you determine an acceptable level of risk and return before investing, if you did?

[Editor's note: Our thanks to Dianecy for the article suggestions. Stay tuned for more!]

More about...Debt, Retirement

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Beth
Beth
5 years ago

When I was in that position, I focussed on my net worth. Ultimately, you’re building your net worth whether you pay back your loan or save/invest. It’s more about what helps you sleep at night than what the numbers say. I saved for retirement and built an emergency fund while paying back my student loan. For me, it was about having savings to fall back on if I needed it — once you pay back your loan, that cash is no longer a resource you can use. It didn’t make sense to sink everything I had into paying a 3%… Read more »

JoeM
JoeM
5 years ago
Reply to  Beth

That decision is easy with a 3% loan. My remaining $18k is between 5.25-6.55%. Then the return on investing vs. debt repayment is a bit murky.

Right now I’m trying to have both. I throw 5% of my gross income in a Roth IRA, 5% in my 401k with a 3% match, and then toss everything I can into my student loans to pay them off quicker.

Sanjeev
Sanjeev
5 years ago
Reply to  JoeM

JoeM,

I think, what you are doing is the best. You are attacking the debt as well as saving for retirement both in 401K and Roth IRA. You are also getting the company match which is good. This is what I also did.

Once the debt was paid off, I saved that money( half and half) for 2 things. 1) buying a house and 2)opened one investment account.

Beth
Beth
5 years ago
Reply to  JoeM

The loan — it was a line of credit, actually — started 6.5% while I was in school but was a variable rated tied to prime so it had dropped dramatically about a year into my paying it off.

I think you’re doing the right thing too, but I’m biased because it’s what I did 😉 I would have done it even if the interest rate was higher because it was about more than a few percentage points.

Bankrupt Blogger
Bankrupt Blogger
5 years ago

Paying off your student loan while thinking of retirement is quite difficult. From my experience most graduates don’t even think about retirement. Most young (and not only young) people also struggle with debt. I mean, let’s face it. It’s not easy to avoid credit card debt nowadays.

Not A Freeloader
Not A Freeloader
5 years ago

there is no need for credit card debt.. if you can’t afford it, don’t buy it. simple enough.

Michael
Michael
5 years ago

I don’t know the ins and outs of all the programs, but I am pretty sure that at least some of the income-based payment plans will come with a massive tax bill at the end of the period because of Discharge of Indebtedness. I have no idea what the figures will end up being but given the current loan interest rates and rising tuition, I would imagine that many will end up with 6 figure Discharges, which will result in a hefty tax bill (if you make say $50,000 at the time of the discharge, that will instantly move to… Read more »

Eric
Eric
5 years ago

Please stop suggesting a CD as a way to “invest”. If you want to present it as a way to “Save”… fine, but a return that is significantly less than inflation is not an “investment”

Sherry
Sherry
5 years ago
Reply to  Eric

Eric, maybe I missed something but it didn’t look to me as though Bill or anyone cited mentioned the CDs as an investment; but rather, a way to parcel out discreet amounts of money to provide payments and a tiny bit of interest to boot.

The overall points of this article were excellent, and I would add that scholarships – pursued vigorously from the time students are still in high school – are another way to avoid student debt.

Eric
Eric
5 years ago
Reply to  Sherry

From the third paragraph…

“investing those same dollars in a CD or index fund”

Adam
Adam
5 years ago

I’ve always prioritized investing over extra payments on student loans. My lower student loan balance wouldn’t be helpful in case of an emergency and paying them off early might just lead to lifestyle inflation once the payments are no longer due.

April
April
5 years ago

I think it’s important to save regardless of amount of debt. I started a small emergency fund with a significant amount of debt. I disregarded interest rates for the sake of my sanity. I felt better knowing I was saving for my future, while keeping my debt in line & paid to build credit. Whether people like it or not, credit (and essentially debt) is necessary to buy some things in life. Unless you have an absurd amount of money you inherited, you would not be reading this article to care to prioritize anyways. The point is we will most… Read more »

Doan Duong
Doan Duong
5 years ago

When I finish college I had about 20k in student loan debt, I elect to make payment on the gradual income plan and consolidate my student loan to some ridiculously low interest rate (less than 3%). Then I proceed to invest the difference between what I would normally pay – the payment on gradual plan, let said $50 a month into a brokerage account. After 10 years from college, I still owe about $10k on student loan, but also have a few k in my brokerage account. If you pay student loan, you can also do some deduction.

Chuckie G.
Chuckie G.
5 years ago

What worked for me was investing while paying off student debt. It was the clear and obvious choice. It became evident that, by taking out student loans, I had traded the gains of future success to live more comfortably (i.e. fulfill the wants) while in school. When it came time to pay, it felt awful. I had miscalculated how willing my future self would be to pay for my past self’s indulgences. Shocking. I know. I then decided that postponing retirement investing for the sake of more expeditiously paying off student loans was to repeat the same scenario; borrowing from… Read more »

Linda Vergon
5 years ago

(This comment came from Joel Frank, a reader of our daily newsletter.)

Dear Mr. Cowie,

The tax code does allow for catch-up contributions. Please see: sections 414(v), 457(b)(3) and 402(g).

Joel L. Frank

Current Pension Topics
The Chief-Civil Service Leader
277 Broadway
NYC 10007

Age
Age
5 years ago

I decided to just pay my 15k student loan off first!! I’m all done and couldn’t be happier. What I decided to do was save 1k for emergencies and just go crazy paying off my student loan. Paid it off in 1.5 years and it wasn’t easy. Now I’m gonna do the same thing for my auto loan which is about 14k paying 1k a month towards my principle amount of the loan. This should only take a year to do. After that I will have NO DEBT. No monthly payments and I can put all my dollars in to… Read more »

Diva
Diva
5 years ago
Reply to  Age

AGE, that’s amazing that you are paying off your debt. Keep going on that. I would just mention that if you have the option of also contributing to a Roth IRA or a 401K at your firm, meeting the firm’s match level, it would be good to start that as well. If you have a firm 401K with a company match, every year that you don’t contribute you miss building a foundation that will grow over time. Also, you’ll miss the “free” money that your firm will contribute. You’re 27 right now so you’re at the perfect age to start… Read more »

Joel
Joel
5 years ago

Dear Mr. Cowie;

The tax code does allow for Catch-Up contributions. Please see: sections 414(v), 457(b)(3) and 402(g).

Best,

JOEL L. FRANK
Pension Columnist
The Chief-Civil Service Leader
277 Broadway
NYC 10007
732-536-9472
[email protected]

susan
susan
5 years ago

Question – my son is an educator in a high-needs school district, and as such, his student loan will be considered paid-off by the government after 10 years (up to $17,000). I would assume, in this scenario, he is better off investing his money and making those minimum payments to his student loans and carrying as much of the student loan debt as possible for those 10 years. Does that sound right to you?

Chuckie G.
Chuckie G.
5 years ago
Reply to  susan

It sounds wrong to me because he borrowed the money and should pay it back.

NMcC
NMcC
5 years ago
Reply to  Chuckie G.

The government sets up financial incentives to encourage behavior that is good for society, ex. the tax-deferred nature of 401k contributions because they want people to save money for retirement. This is just another example of that – they have a shortage of professionals for certain necessary positions so they create an incentive for people to work there with extra compensation. This is what the private sector does too – in demand positions pay more. So what if the extra compensation comes in the form of loan forgiveness rather than straight cash? How does it make a difference? Would you… Read more »

Michael
Michael
5 years ago
Reply to  susan

I agree entirely with NMcC. I would also that this forgiveness comes with a fairly long tie in (in this case 10 years) so it is far from being a free lunch. As to the original question, if this loan is being forgiven tax free (and I believe it is), then by all means invest rather than pay down the loan. This all assumes the loan balance will be at or about the $17,000 forgiveness threshold. If not, I would maybe split any “additional” funds between investment and loan. I say this because I would try to get close to… Read more »

JoeM
JoeM
5 years ago
Reply to  Michael

This plan – and PSLF – are tax free write-offs, so yes, if the teacher does not plan on leaving before their commitment is up, paying the minimum is the best route to take. The same goes for social worker friends. $30-50k in debt for a MSW from a good school just to get a $35k/year job after school? I’m completely fine with them using IBR to pay a measly $100/month (instead of the $400-700 on a traditional repayment plan) and getting the outstanding balance written off, tax free, in 10 years. In 10 years, that social worker might be… Read more »

Joel
Joel
5 years ago

Is there a link between the nation’s mental health crisis and the salaries earned by mental health professionals?

Steve
Steve
5 years ago

I’m looking for some advice from this group. Bit of context: I am 36 and very, very unlikely to ever lose my job. I have kid #1 on the way. I own my 100K home outright (although I have a HELOC at 3.15% with about 15K on it). I make about 70K a year. I have 9K emergency fund in I-Bonds. 81K in 403b and 10K in Roth. I went to graduate school and finished my degree with I was 27 and landed my first paying job at 28, which is why I’m a little behind on my retirement funding.… Read more »

Doan Duong
Doan Duong
5 years ago
Reply to  Steve

If I am in your shoe I would put half toward my student loan and the other half into a vanguard account. Can you consolidate to get a lower interest? Can you get better than 5% return in your investment? Would you feel better having the school loan paid off, or having a sizeable investment in brokerage account. Everyone have different comfort level and risk taking.

Steve
Steve
5 years ago
Reply to  Doan Duong

That’s an interesting idea that I had not considered. I can’t consolidate the student loan down further. Part of the reason the calculation is so complicated is that normally I get a tax deduction for the student loan interest (about $450 a year) and I would have to pay capital gains on returns on the brokerage account. I would definitely feel better without the student loan. I would also feel pretty good having a year’s salary tucked away working for me.

Sam
Sam
5 years ago
Reply to  Steve

Steve, I realized this is a little late in the game, but wanted to add my 2 cents. First, that’s great that you’re getting this windfall opportunity, and it sounds like you have a solid understanding of some of the tax consequences. The one thing I can add (just to complicate things further!) is that the student loan interest deduction actually lowers the bar for the return you’d need to “outperform” paying off the loans. It looks like you’re normally in the 25% tax bracket, excluding the windfall, so really your after-tax return would need to be something like 3.7%… Read more »

Scott
Scott
5 years ago

For me the debt was overwhelming initially and if I hadn’t already started investing years prior I would have cashed in and given up completely on my retirement account. Thankfully, I started a DSPP and DRIP at the age of 18 before I even graduated high school. I developed a discipline of putting money in, even though I had little and needed more to pay for rent and school. Now I can do both and make a great impact on each.

Kate
Kate
5 years ago

We had such a large amount of student loan debt (but nothing else) that it was unrealistic to buckle down and pay it first before starting retirement savings, buying a house, having savings, etc. We ended up splitting money between the student loans (<3% interest), retirement, and savings. We ended up buying a home, although the majority of our down payment was gift money earmarked for a home. If we had a lower student loan balance and could have paid it off in a few years, it would have been reasonable to make some sacrifices and get it out of… Read more »

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