Is it better to pay off student loans or invest?

Balancing financial priorities can be tricky, and you may wonder whether you should prioritize paying down student debt or investing in long-term goals. The correct answer for you will hinge on the interest rate of your student loans and your ultimate financial objectives.

If you desire to become debt-free quickly, putting your extra money toward removing student debt is ideal. On the other hand, investing could be a better option if your expected rate of return is higher than your student loan’s interest rate or if you want to work on your financial security. If your budget allows, you could also choose to do both.

Paying off student loans early: Pros and cons

You should consider paying off your student loans if you want to prioritize removing debt, have high interest rates or an unpredictable cash flow.

Pros

• You’ll save hundreds of dollars in interest. 
• You’ll become debt-free sooner to and work toward other financial goals.
• Improve debt-to-income ratio (DTI), increasing your chance for mortgage approval.

Cons

• Lengthy repayment period that can go on for several years.
• May not be beneficial, especially if you’re working toward loan forgiveness or repayment assistance. 
• Can cause you to miss out on potentially greater returns through investments.

Best for these situations

• 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 can’t because of a high DTI.

Investing over student loans: Pros and cons

If the rate of return for your investments will be higher than the interest rate for your loans, it might be a good idea to take advantage of compound interest and start investing.

Pros

• You might get a better rate of return.
• Investing sooner may help you retire sooner.
• Certain investment accounts have flexible withdrawal rules if you need liquid funds.

Cons

• You may still struggle with your monthly student loan payments.
• Investing won’t help improve your DTI.
• Investments come with the risk of losing money — returns aren’t guaranteed.

Best for these situations

• 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.

4 Important factors to consider

“Graduates need to consider what is more important – building wealth or getting out of debt? And what will allow you to sleep at night?” says Jack Wang, Wealth Advisor at Innovative Advisory Group and host of the “Smart College Buyer” podcast. There is no one-size-fits-all answer, and the answer is likely to change over time.

As students and graduates consider this balancing act, Wang advises, “Interest rate or rate of return doesn’t matter here as much as people think. It’s really about giving [savings and investments] time to grow, even if it is at a lower rate of return. It’s about getting the magic of compound interest to work for you,” he adds.

Here’s what to think about when deciding between paying off your student loans and investing:

1. Personal financial goals

Start by thinking about your overall financial profile. You need to consider other debts, savings goals and personal priorities. Here are some other goals you might decide to prioritize:

• Save for emergencies: Before paying off student loans or investing, save at least one month’s 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 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 want 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 other financial milestones.

A final personal priority to consider is whether becoming debt-free is your top goal. If so, you may want to hold off on investing and put all excess funds toward paying off your student loans early.

2. Interest rates

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 over 17 percent. Compare your student loan interest payments to your expected investing return. Stocks can generally offer a long-term rate of return of over 9 percent a year. However, returns can be volatile if you invest for the short term.

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.

3. Tax deductions

When you’re paying off student loans, you may 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.

4. Forgiveness programs

If you have federal student loans, you may be able to get student loan forgiveness, which eventually cancels all or some of your student loan debt. Make sure to look closely at loan forgiveness details to ensure eligibility.

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.

Bottom line

Deciding whether to pay off student loans or invest depends on your financial goals and which option gives you a better return. If the rate of return on your investments is higher, then making minimum payments and investing your extra cash may be a good choice. On the other hand, if your student loan interest exceeds possible investment returns, you may want to prioritize your debt payoff.

It’s important to note that, depending on your financial situation, you may not have to choose to invest over repaying student loans faster or vice versa. If you need help deciding what to do, contact an investment professional.