Paying Off Student Loans vs. Investing: Which Should You Prioritize?

Weigh the benefits of paying off your student loans versus investing

You probably know that investing is an important part of building wealth for the future, but if you have student loans, you may feel like you need to get them paid off before you begin investing. Neither option is inherently better than the other, as the "right" one to prioritize will depend on your goals and how comfortable you are having debt. Before you decide between using extra cash to either pay down student loans or invest, you'll want to ensure you fully understand your financial situation.

Key Takeaways

• Evaluate the benefits and drawbacks of paying down federal student loans versus private student loans before you make a decision.
• Consider the impact of interest rates on student loans compared to potential investment returns.
• If you can afford to do so, you may want to put portions of your discretionary income toward both investing and paying down your student debt.

Paying Off Student Loans vs. Investing: An Overview

Paying off student loans early can bring peace of mind, in addition to reducing the amount of interest you pay over time. On the other hand, investing works best when you start early and be consistent. The potential returns might outweigh what you're paying in interest.

Factors to Considers

Personal Financial Goals

First, think about your financial goals and priorities. Prioritize whether you want to be debt-free faster or build wealth for the future. Carefully think about which goal makes the most sense for your situation. Perhaps you need to get out of debt to qualify for a mortgage before you save for retirement. Or maybe you're comfortable carrying some debt and want to build an emergency fund to prepare for unexpected expenses first.

In some cases, student loan debt can keep you from reaching other goals. By paying it off, you might feel more freedom to make progress in other areas of your life. On the other hand, you might want to build wealth earlier by putting your extra money to work through investing.

You may be able to invest and work toward paying off student loans by budgeting portions of your discretionary income for both.

Interest Rates

Interest is the money you pay to borrow money. Student loan interest rates vary, so some of your loans might have higher rates than others. Even if you consolidate your loans to one interest rate, you're still paying interest.

Plus, if you had interest accrue during your time in school, or during a deferment or forbearance period, it's likely been added to the balance of your loan and you're now paying interest on that interest. The faster you pay off your loans, the more money you save in the long run.

Let's say you consolidate your federal loans. The formula for determining your interest rate for a loan consolidation takes your balances and statutory interest rates into account. To determine your new consolidation loan balance and interest rate, total the balances and average the interest rates of the loans you're consolidating, rounded up to the nearest one-eighth of 1%. Say you have the following undergraduate unsubsidized loans:

• $5,500 at 5.05%
• $6,500 at 4.53%
• $7,500 at 2.75%
• $7,500 at 3.73%

In this case, a consolidation loan would be for $27,000 and have an interest rate of 4%.

If you're concerned about compounding interest and you have an interest rate that's high relative to potential returns, focusing on repaying student loans might make sense.

By inputting your loan term, principal amount, and interest rate into a loan calculator, you can calculate the total interest expense on different loan types.

Potential Returns on Investments

Paying off debt is often considered a "guaranteed return" based on your interest rate. But what if your potential returns on your investments are higher than the interest rate you pay on your student loans?

In the example above, you're paying 4% on your student loans. However, the long-term average annual return of the S&P 500 is about 10%, more than twice the rate of some student loans. In that case, you might be better off putting more of your discretionary income toward investing, since your returns could be much higher than what you'd paying in interest.

Keep in mind that the stock market can be risky and isn't guaranteed to provide returns each year.

Type of Student Loan

Compared to federal loans, private student loans typically have different terms and access to fewer benefits and programs. In that case, you might decide to tackle your private loans first. Then, you may want to address your federal student loans or choose to invest first.

If you're not eligible for federal student loan repayment programs, you may also be able to refinance all of your private and federal loans together into one private loan with the same term but at a lower rate. Then you can reduce your debt faster without paying as much.

Note

Carefully consider your financial situation and your future earning potential as you evaluate the types of student loans you have. In many cases, it might be better to not refinance federal and private loans together and pay them down separately.

Tax Deductions

You can potentially deduct up to $2,500 of your student loan interest when you prepare your taxes. This can lower your taxable income and reduce how much you owe. In some cases, depending on your rate, the tax deduction might offset a portion of the interest you pay.

A quick way to estimate your tax deduction is to multiply the dollar amount of your total interest payments by your tax bracket. For example, if you pay $1,500 in student loan interest during the year and you're in the 22% tax bracket, your deduction is worth $330. That's not enough to fully negate your interest, but you might decide it's enough to adjust how you allocate money for paying off student loans versus investing.

Forgiveness Programs

Finally, consider whether you're eligible for federal forgiveness programs. Private student loans aren't eligible for forgiveness, but federal loans might be.

• If you're on an income-driven repayment (IDR) plan for 20 or 25 years, your balance might be forgiven.
• The Saving on a Valuable Education (SAVE) Plan doesn't accrue interest if you make your full payment each month and it isn't enough to cover the interest that would've accrued.
• If you’re employed by a government or not-for-profit organization, you might be eligible for Public Service Loan Forgiveness after making 120 qualifying payments.
• Other loan programs, like the Teacher Loan Forgiveness Program and state programs aimed at healthcare providers, are also possible options.

If you can get a lower monthly payment that frees up more money to invest, and you know you'll get some level of student loan forgiveness, it'll be easier to make building wealth a priority.

Paying Off Student Loans Early

You should prioritize paying off student loans early if...

• You have high-interest student loans, especially private loans
• Having debt causes emotional stress and being debt-free would offer peace of mind
• You don't qualify for any IDR plans or student loan forgiveness programs
• A high student loan balance is keeping you from reaching other goals
• Your employer offers student loan repayment assistance

Pros and Cons of Paying Off Your Student Loans First

Pros

• Pay less in total interest

• Peace of mind from paying off debt

• Better ability to reach other financial goals

Cons

• Opportunity cost with money that's not invested

• Missing out on potential debt cancelation benefits

How to Pay Down Student Loan Debt Faster

You can take several steps to pay down your student loan debt more quickly. These include:

• Making bi-weekly payments instead of monthly payments to get an "extra" monthly payment each year
• Designating extra payments to go toward the principal, instead of pre-paying fees and interest
• Cutting back on unnecessary costs and putting the savings toward paying down student debt
• Looking for ways to earn extra money to put toward your student loan payment
• Putting windfalls, such as tax refunds, bonuses, or gifts, toward your loan repayments

Investing Toward Other Goals

You can prioritize investing if...

• Your employer offers to match the amount you invest (such as with a company 401(k) plan)
• Your student loan interest rate is low and you expect long-term returns in invested assets to be higher
• You can maximize tax deductions from both retirement contributions and student loan interest
• You expect to be eligible for student loan forgiveness and qualify for an IDR plan
  

Pros and Cons of Investing

Pros

• • Potential for higher returns over time
  • Start building wealth immediately, with the potential to retire earlier
  • Might be able to take advantage of an employer match

Cons

• • Returns might not always be sufficient
  • There's a risk of loss of principal when you invest

Should I Use All My Savings to Pay Off My Student Loans?

Before deciding to use all your savings to pay off student loans, consider what you might need that money for. For example, you may want to build an emergency fund to protect yourself from large medical bills or other unexpected expenses.

What Are Some Strategies to Pay Off Student Loans Faster?

Some strategies to pay off student loans faster include putting extra toward the principal by making bi-weekly payments, cutting back on costs, and finding ways to supplement your income.

What Are the Advantages of Federal Student Loans Compared to Private Student Loans?

Federal student loans offer benefits that private loans don't provide, such as IDR plans, deferment in some cases, and loan forgiveness when certain conditions are met. Additionally, there are no credit requirements for undergraduate student loans, and interest rates are the same for each loan in a given year.

How Long Does it Take to Pay Off Student Loans?

It depends on your plan. The Standard Repayment Plan is 10 years, while some consolidation loans can have a repayment period of up to 30 years. IDR plans offer payoffs of 20 or 25 years, and some forgiveness programs provide earlier cancelation. You can also pay off your loan early using extra payments.

The Bottom Line

Whether you're better off paying down student debt or investing will depend on your situation, financial goals, and how you feel about debt. Additionally, it's important to realize that it's not an either/or situation. You can always invest a portion of your discretionary income while still tackling your student loan debt.

Read the original article on Investopedia.