Should you pay off student loans or invest?

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After paying your bills, shopping for groceries and doing your personal spending, you might have money left over at the end of each month. It might be tempting to splurge on a big vacation or just spend more. But it’s better to use that extra money to get ahead, whether you plan to boost your savings, pay off student loans or invest. If you have a large student loan balance, you may want to put all extra funds into paying off those loans. However, generally, investing is a better option to explore when you can reasonably expect a return that’s higher than your student loan interest rate.

Factors to consider when deciding whether to pay off student loans or invest

If you have extra cash at the end of your month, should you pay off student loans or invest? In short, there’s no right answer. A lot goes into this decision — like your expected return and your personal priorities — and it depends on your own situation. Here’s what to think about when considering if you should pay off student loans or invest.

Interest rates

The first step is figuring out whether you’ll get a better return through investing or through paying down your student loans.

Depending on when you borrowed the money, interest rates on federal loans range from about 3 percent to 7 percent. Private student loan interest rates are usually higher. Paying down your debt is like a guaranteed return on the money, so if your student loan interest rate is 5 percent, then you’re getting a 5 percent return.

Next, take a look at your expected investing return. Money market accounts and certificates of deposit generally get a low return, around 1 to 2 percent. Stocks can offer a much higher return, around 10 percent annually in a strong economy, but they’re more volatile. A conservative but realistic return on investments is around 6 percent a year.

If your student loan interest rate is lower than what you can realistically expect to earn investing, then it could make sense to prioritize investing over paying down student loans early.

Tax deductions

When you’re paying off student loans, you might be able to deduct interest payments on that debt. Eligible borrowers can lower their taxable income by up to $2,500, which helps offset the cost of student loans over time.

Forgiveness programs

If you have federal student loans, you might be able to get student loan forgiveness, which eventually cancels all or some of your student loan debt. And if you qualify for Public Service Loan Forgiveness, you won’t have to worry about the tax consequences of the debt forgiveness.

If you plan to take advantage of student loan forgiveness, then it might not make sense to make extra payments toward the debt, since making extra payments won’t get you to loan forgiveness any faster. You could instead put the extra money toward investing and grow your money over time.

But look closely at the loan forgiveness details. When you enroll in income-driven repayment plans, such as Pay As You Earn (PAYE), you’ll get a tax bill after the program is complete, since forgiven loan amounts are considered taxable income. You also might pay more in interest because the loan terms are stretched over more years. This may affect your decision to enroll in one of these programs or to start investing now.

Personal priorities

Your student loans and investments are only two pieces of your overall financial picture. You need to consider your other debts, savings goals and personal priorities. Here are some other goals you might decide to prioritize:

  • Save for emergencies: Building a savings account should be your first priority, because it can help you stay afloat during financial emergencies. So before you pay off student loans or invest, save at least one month’s worth of expenses. Over time, try to build up to six months’ worth of expenses.
  • Save for retirement: It’s always a good idea to start your nest egg early and give it plenty of time to grow. If your employer offers a 401(k) match, take advantage of it.
  • Pay off high-interest debt: Credit card balances, personal loans and other types of debt might have higher interest rates than your student loans or your return on investments. Paying these off first can give you a higher return than investments or student loan debt.
  • Tackle big life goals: If you’re looking to have kids or save for a house down payment, you might decide to make minimum payments on your debt and hold off on investing for now.

Use this list to start thinking about your financial and life goals. Which ones do you want to accomplish first, and what else is on your plate? Once you get an idea of what’s important to you, set up a plan of action.

How to invest when you have student loan debt

If you’ve decided to start investing, first figure out how much you can put toward this goal every month while still making student loan payments. Add up your monthly expenses (including a little bit of spending money) and subtract this amount from your monthly post-tax income. What’s left is fair game for investing. Here are a few ways to try investing:

  • Use an investing app. Some apps, such as Stash or Acorns, let you start investing with as little as $5. These are great for people who are new to investing or who need a little help managing their investments.
  • Hire a broker. A stock broker is a person or company that buys and sells shares on your behalf. You may decide to look for low-cost online brokers, like Fidelity Investments, or go for a free service like Robinhood.
  • Buy an S&P 500 index fund. An S&P index fund has shares of all the stocks in the index, which helps you diversify your investment and get a less volatile return.

The bottom line

The question of whether to pay off student loans or invest mainly comes down to which option gives you a better return. If the rate of return in investing is higher than your student loan interest, then you might decide to invest. Just make sure you’re making the minimum payments toward your student loan in the meantime.

Featured image by UfaBizPhoto of Shutterstock.

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