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If you have some money left over every month, it can difficult to decide whether you should pay off your student loan debt or invest your money.
In the past, traditional advice advocated investing whenever possible, but is that still the case? Student loan interest rates change often — federal loans can be as high as 7%, and private student loans can be as high as 14% — so investing may not be the best course of action. Find out what you should consider when deciding what to do with your money.
When to consider before deciding to invest or pay off your loans
When young borrowers had extra money, many financial experts encouraged investing rather than paying down student debt. And they have a convincing argument. Time is on your side, and your investments could grow and earn higher returns.
However, that advice was based on student loans having low interest rates, which they did in the past. For example, when your loans have an interest rate of just 4%, it might make sense to invest because your money could work harder for you in investments where the returns might be greater than 4%. Therefore, if you have student loans with low interest rates, it might make sense to hold off on paying them off so you can free up money to invest, understanding, of course, investments are usually not guaranteed to have a specific return rate.
However, interest rates on student loans can go up or down. As they go up, it can be harder to find investment opportunities that provide a higher rate of return than the cost of your student loan rate. In such circumstances, it may be a better choice to pay off your student loan debt.
What to prioritize before investing or paying off your loans
Before you even think of investing, it’s important to make sure you’re paying at least the minimum monthly payment for your student loans on time. Then, before deciding between investing and paying off your loans more quickly, there are other financial milestones you may want to hit first to ensure you’re in a strong financial position.
- Start an emergency fund: It’s essential to have a cash buffer in case of emergencies. Set aside $500 to $1,000 in a savings account to start before allocating money for investments or student loans. Then, set aside some money each month so you can build up three to six months worth of expenses.
- Contribute enough to your retirement fund: If your employer offers a company match on 401(k) contributions, contribute enough to get the full match. Otherwise, you’re basically leaving free money on the table. So make sure your IRA or other retirement accounts are being contributed to.
- Prioritize-high interest debt: If you have other high-interest debt, such as credit card debt, they should be your priority. You’ll get a higher return on investment knocking the high-interest debt out first.
- Reduce your interest rates: If possible, try to lower your interest rates on your student loans through refinancing. Student loan refinancing can help you save money and pay off debt ahead of schedule.
Once you’ve accomplished these things, then you can put extra money toward your next goal.
5 signs you should pay off student loans instead of investing
If you’re not sure what makes the most sense for you — paying off your student loans or investing your money — here are five reasons your student loans should be a priority.
1. If you want a higher rate of return more quickly
According to Vanguard, the average rate of return on the stock market over the past year was only 3.04%. Compared to the student loan rates that are now over 5%, you’d earn a higher rate than the 3.04% you would by investing for the year.
So, if your strategy is to pay down your debt as soon as possible, it could make more sense to pay down your student debt when expected market returns are lower. However, if you look at the average rate of return on the stock market over a 10-year period (10.49%), it could be wise to invest if your strategy is the long term rate of return. You’ll have to decide which strategy is best for you in the long run.
2. If you want to lower your debt-to-income ratio
When you pay off your student loans, you’ll also lower your debt-to-income ratio or the amount of debt you have relative to the amount of money you make. Your debt-to-income ratio is a big deal. It’s a major factor in determining your credit score, and it’s what creditors use when deciding whether or not you can handle other forms of debt, such as a car loan or a mortgage.
The lower your debt-to-income ratio, the better. If you plan on buying a home or making a major purchase in the near future, paying off your debt will help your chances of getting approved for a loan.
3. If you need more breathing room in your budget
Your monthly payment likely eats up a significant part of your monthly budget. If you had $35,000 in federal student loans at 6% interest, your monthly payment would be $333 a month. If you aggressively paid off your student loans, you could free up that monthly payment. That would give you over $300 each month to invest or pursue your other financial goals.
4. If you’re not able to reduce your student loan interest rates
If you put your extra money toward your high-interest student loans, you might be able to get out of debt sooner.
For example, let’s say you had $35,000 in student loans at 7% interest and a monthly payment of $400. If you paid an extra $50 a month toward your loans — a relatively small amount — you’d pay off your loans 19 months ahead of schedule. Even better, you’d save $2,340 in interest.
But you could save even more by refinancing your student loans. With refinancing, you could lower your interest rate, so more of your payment goes toward your principal. Let’s say you refinanced and qualified for a 4% interest rate on that same loan. You’d save more than $6,243 over the life of the loan, and that’s without making extra loan payments. That would free up money you could use for investing.
Just keep in mind that although you’ll save over the life of the loan, your monthly student loan payment will increase. This means you might not be able to start investing until your loan is paid off — unless you have more disposable income.
5. If you crave more peace of mind
Personal finance is just that — it’s personal. Sometimes the biggest factor in determining what makes sense is more emotional than practical. If you’re the type of person where your debt weighs on you and you lose sleep over it, paying off your loans ahead of schedule rather than investing can be priceless because it will give you peace of mind and a sense of security.
Paying off student loans and investing can go hand in hand
When deciding between investing your money and paying off your student loans, it’s important to consider multiple factors of your financial situation. Your loan interest rates, potential returns, and financial goals should all influence your decision-making process.
Once you consider all options — and your personal finances — you’ll be able to see more clearly which option is best for your situation. And sometimes that might even mean both paying your loans off quickly and investing a little, as well.
If you decide to accelerate your student loan pay off, find out how refinancing your student loan debt can help you save money and pay it off faster.