Should You Pay Off Student Loans or Invest?

Student loan debt can feel like a heavy weight, especially when you're trying to build long-term wealth. Around 84% of borrowers say their student loans reduce how much they can save for retirement, according to a survey by the Teachers Insurance and Annuity Association and the MIT AgeLab. Among those not saving for retirement, over a quarter (26%) cite student loan payments as the primary reason.

This often begs the question: Should you pay off student loans or invest? In this guide, learn what to consider when paying off student loans or creating an investment strategy.

Current private student loan refinance rates

Should you pay off student loans or invest?

Whether you should pay off student loans or invest is a personal decision and depends on a number of factors. What's right for someone else might not be the right solution for you.

10 things to consider

Here are factors to consider regarding your financial planning with student loans:

1. Financial cushion

Do you have a solid emergency fund of three to six months' worth of expenses? If the answer is no, building a financial cushion is more of an immediate need. An emergency fund can help you handle surprise situations that inevitably come up.

2. Interest rates

Compare the interest rates on your student loans versus the expected return on your investments. Typically, you want to focus on the higher number for maximum impact.

3. Student loan type

Federal student loans tend to have lower interest rates, while private student loans often have higher rates. Private loans also don't come with the same benefits, so it can make sense to prioritize paying them off.

4. Loan balances

Review your balances to see how much you owe in student loans compared to how much you have invested. If your student loan balance is low, you might want to pay it off quickly and then focus on investing.

5. Tax benefits

You may want to take advantage of tax benefits by paying your student loans and investing in your 401(k). Depending on your income and eligibility, deducting up to $2,500 in student loan interest each year is possible. Putting money into your 401(k) lowers your taxable income, which can help you pay less in taxes (however, you're responsible for taxes upon withdrawal in retirement).

6. Employer benefits

Does your employer offer student loan repayment assistance and/or a 401(k) match? Take advantage of any student loan or retirement benefits. If one is worth more, that may influence where to focus.

7. Age

Your age affects your time horizon, or how long you must invest until you reach your goal. It's a very different situation if you're 25 compared to 45 or 55. If you're older and many years out of college, you generally can't afford not to invest.

8. Forgiveness opportunities

Federal student loan borrowers may be eligible for Public Service Loan Forgiveness (PSLF) or income-driven repayment (IDR) forgiveness. If you qualify and want to pursue student loan forgiveness, it doesn't make sense to pay more than the minimum since your goal is to get the loans discharged.

In this case, focus on investing while making the minimum payments on your student loans. If you're not going for forgiveness, you might consider student loan refinancing — but weigh the advantages first, as you'll no longer qualify for federal loan benefits after you refinance.

9. Emotional well-being

If your student loan debt is affecting your emotional well-being or causing undue stress, paying it off can pay greater dividends for you overall than investing.

10. Risk tolerance

When weighing investing vs. paying off debt, it's crucial to consider your risk tolerance. Paying off debt is a surefire way to lower your balance and pay less interest. On the other hand, investing always has some level of risk and is more of a gamble. Your risk tolerance is how much risk you feel comfortable investing. If you're extremely anxious about the market's volatility, that may influence your decision.

Benefits of paying off student loans early

Debt is costly, so there are major benefits to paying off student loans early, including:

• Save money on interest: You could pay significantly less in interest charges over the life of your loan if you pay off student loans early.
• Improve cash flow: Monthly student loan payments may take up a substantial part of your budget. Paying off your student loans frees up that money each month, improving your cash flow. The funds can then go toward your emergency fund, investing, or other financial priorities.
• Lower debt-to-income ratio (DTI): Your debt-to-income ratio is the percentage of income you pay toward debt each month. While your DTI doesn't impact your credit score, it's a metric that lenders typically look at when you apply for a mortgage or new credit. Lowering your DTI may help your approval odds.
• Become student debt-free sooner: You can shave years off your repayment term by paying off student loans early, which means one less payment to worry about.
• Ease emotional burden: When you pay off debt, you might feel lighter and less stressed because you don't have the obligation hanging over your head.

Early student loan payoff example

To take a closer look at interest savings, let's say you have a student loan balance of $30,000 with a 6.80% interest rate and a 10-year loan term. Your monthly payment is $345 per month. If you decide to put an additional $100 toward your debt each month, you'll save $3,531 in interest.

Consider the tax deductions for student loan interest

Depending on your tax situation, you might qualify for a student loan interest deduction to help you prioritize your financial goals.

The IRS lets student loan borrowers deduct up to $2,500 in annual interest paid for taxpayers with a modified adjusted gross income (MAGI) of $70,000 or less — or a MAGI of $145,000 or less for borrowers who file jointly.

Benefits of investing before paying off loans

Depending on the size of your student loan debt, it can take many years to pay it all off. If you don't invest during that time, you could miss out on precious time and the power of compounding. Some benefits of investing before you pay off student loans include:

• More time to compound: The longer you have money invested, the more time you have for the power of compound interest (interest earned on the money you've saved) to do its magic. That can accelerate your growth and build wealth.
• Attractive returns: You may get a higher rate of return investing instead of paying off debt. The stock market has typically provided annual returns of 10%, or 6% to 7% when accounting for inflation, according to the Securities and Exchange Commission (SEC).
• Get an employer match: If you invest in your retirement and secure an employer match before paying off student loans, that's free future money you get as part of your compensation package. Note that it's typically best to contribute to your retirement fund at the same time as you pay off student loans, even if you can only contribute a small amount to a 401(k).
• Build a nest egg faster: Investing now before paying off your student loans means building your nest egg faster. That can mean more financial security and the potential for retiring early or more retirement possibilities.
• Potential withdrawal: If you invest money in a Roth IRA, you have some flexibility with the funds and can withdraw your initial contributions early (not earnings) without any penalty or tax consequences. For other retirement vehicles, you pay an early withdrawal tax of 10%, but there are exceptions, according to the IRS. These include adopting a child, disability, or emergency personal expenses. While it's best to avoid tapping retirement funds, in some situations, the money can help you in a bind. 

Investing example

To show the power of time in the market and compound interest, let's look at an example. Imagine you're starting at $0 invested today. But you decide to contribute $100 per month to investments instead of extra student loan payments.

With an interest rate return of 7.00%, you can see the major differences in the projected investment total based on the length of time. In 10 years, you're projected to have over $16,000. At 20 years, the time is now doubled, but your projected investment total nearly triples. At 30 years, you exceed six figures in investments, according to Investor.gov.

Balancing both: Paying off student loans and investing simultaneously

When considering student loan payoff strategies, you might feel like going all in and neglecting investing. But there's no rule saying that you can't balance both paying off student loans and investing at the same time. Doing so can save you money in interest and help you build wealth, so when you're finally free of debt, you have some assets to your name.

Let's look at how, using the same numbers as above. Instead of putting $100 to pay off student loans or invest, let's say you split that and put $50 toward your student loans and $50 toward your investments.

Paying off student loans and investing example

If you have a $30,000 loan balance at 6.80% with a 10-year loan term, paying $50 more on your student loans saves you $2,096 in interest. If you put $50 toward investments for 10 years with a 7.00% rate of return, your projected investments are $8,289.87.

Remember, if you put $100 more toward your student loans for 10 years, you'll save $3,531 in interest. If you invest the $100 at 7.00%, you'll have $16,579.74 after 10 years.

In this case, investing can get you the most out of the extra money. But as you can see, putting $50 toward student loans and $50 toward investments still gets you much further than putting $100 only toward your student loans.