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After paying your bills and covering necessary expenses each month, you may have money left over. While it’s tempting to splurge, it’s usually better to use that extra money to make extra payments on outstanding debt or invest.
If you have a large student loan balance, you may want to put all extra funds into paying off those loans. However, investing could be a better option to explore when you can reasonably expect a return that’s higher than your student loan interest rate.
When to pay off student loans
Paying off student loans before investing can take some time, but for many borrowers, it can relieve a lot of stress and free up more cash for other goals, including investing. It can also make your life feel a little less complicated. You should consider paying off your student loans if you have high interest rates, you have an unpredictable cash flow or you’re looking to remove debt from your finances.
- You’ll save money in interest.
- You’ll become debt-free sooner.
- Your debt-to-income ratio (DTI) will improve, making it easier to qualify for a mortgage.
- It can take several years to pay off your student loans, even with extra payments.
- It’s unnecessary if you’re working toward loan forgiveness or repayment assistance.
- You won’t be able to maximize the student loan interest deduction.
- People whose top priority is to be debt-free.
- Borrowers with high-interest student loans (8 percent or higher).
- Borrowers who have private student loans with a variable interest rate.
- People hoping to purchase a home but who can’t because of a high DTI.
When to invest
Investing sooner rather than later can help set you up for a successful retirement as you take advantage of the power of compound interest. While investing never offers a guaranteed return, if your research shows that the rate of return for your investments will likely be higher than the interest rate for your loans, it could be a good idea to start investing.
- You can often get a better rate of return than most student loan interest rates.
- Investing sooner will help you avoid having to work longer in your older years.
- With certain investment accounts, you can take withdrawals if you need the money in the future.
- You may still struggle with your monthly payments.
- Investing won’t help improve your DTI.
- Investing can be extremely risky.
- Borrowers with a low interest rate on their student loans.
- Borrowers who are enrolled in a student loan forgiveness plan.
- People who already have investing knowledge.
Pay off student loans or invest: Factors to consider
Cecil Staton, president and wealth advisor at Arch Financial Planning, says that when it comes to choosing between paying off your loans and investing, it’s more a question of “opportunity cost.”
“Do you expect a higher rate of return than the interest rate charged to your student loans?” Staton says. “If so, it could make sense to invest. If not, aggressive repayment strategies may be in your best interest, and you may delay investing. Ultimately, a balance between the two usually makes sense.”
Here’s what to think about when deciding between paying off your student loans and investing.
Start by thinking about 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: 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: If your employer offers a 401(k) match, take advantage of it. Explore other opportunities outside of a 401(k) to start contributing to retirement accounts and saving for your retirement.
- Pay off high-interest debt: Credit card balances, personal loans and other types of debt might have high interest rates. 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. This gives you space in your budget to save for those bigger financial milestones.
A final personal priority to think about is whether becoming debt-free is a top goal for you. If so, you may want to hold off on investing and put all excess funds toward paying off your student loans early.
Depending on when you borrowed the money and whether you have federal or private student loans, interest rates can range anywhere from 1 percent to 13 percent. 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.
Compare this rate of return to your expected investing return. Stocks can generally offer a long-term rate of return of over 9 percent a year. If you’re investing for the short term, however, returns can be volatile.
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.
When you’re paying off student loans, you might be able to deduct interest payments you make 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.
At the same time, you can also deduct contributions made to a 401(k) or traditional individual retirement account. Think about which tax break is more important to you.
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. If you plan to take advantage of student loan forgiveness, then it doesn’t make sense to put extra payments toward the debt. You could instead put the extra money toward investing and grow your money over time.
But look closely at the loan forgiveness details to ensure that you will meet the qualifications. This may affect your decision to enroll in one of these programs or to start investing now.
The bottom line
Deciding whether to pay off student loans or invest depends on your financial priorities and which option gives you a better return. If the rate of return in investing is higher than your student loan interest, then making minimum payments on your student loans and putting any extra cash toward investing may be a good choice. Conversely, if your student loan interest is higher than any possible return on investment, then focusing on getting out of debt faster may be the better path.