It’s a dilemma that every 20 or 30-something faces at some point: when it comes to your financial priorities, should you put investing or paying off your student loans first? After all, you’re told that the best way to invest for your future is to start early — but also that you should pay off your debt as soon as possible. In the face of this competing advice, how can you know what the best decision is?
There is no one right answer for everyone, of course; the answer will depend on your personal financial situation and your goals. But there are many factors that you should consider and advantages and disadvantages to each choice. Here are a few factors that you should consider when deciding which strategy you should take for your financial future.
While it may seem counter-intuitive, there are certain pros to keeping your student loan debt — and one of them comes in April, when it’s time to pay your taxes. That’s because the Internal Revenue Service (IRS) may allow you to deduct up to $2500 of your taxable income in student loan interest each year, which can add up to a significant savings on your annual tax bill. If you pay off your student loans, you lose that tax deduction — which could actually increase your taxes. When it comes to taxes, it may make more sense to invest your money in high quality blue chip stocks rather than use it to pay off your taxes.
Compound Interest: Pros and Cons
One of the most frustrating things about paying off your student loans is how little of your payments actually seem to go towards the principal. For most borrowers, it seems as though your payments largely go to principal — and that you never really make a dent in your debt as a result. This is due to compounding interest, which essentially means that you are paying interest on top of interest. When it comes to debt, compounding interest is a bad thing, and a good reason to pay off your loans first.
But it isn’t quite as simple as that — at least not when it comes to the decision to invest or pay off your student loans. That is because many student loans, especially federal loans, have a relatively low interest rate, often between three and ten percent. In contrast, many investment opportunities — such as retirement accounts — have a rate of return of around seven or eight percent. If you are getting a larger rate of return on your investments than you are paying on your student loan interest, then it may make sense to invest rather than pay off your loans.
That’s because compounding interest can also work in your favor, by building up your investment when you start early. That same interest rate that can seemingly increase your student loan debt exponentially can also help you build up a sizable investment, particularly when you start early. If your rate of return on an investment is greater than your interest rate on your student loans, then it may make sense to invest rather than pay off your student loans.
Of course, this does not apply if you have a high interest rate on your student loans. In that case, you may want to refinance your private student loans to get a lower interest rate, and then reevaluate your decision to invest or pay off your student loans based on your lower interest rate.
Consider a Hybrid Approach
When it comes to paying off your student loans or investing, remember that it doesn’t have to be an all-or-nothing decision. Paying even a little bit more each month on your student loans can save you thousands of dollars over the life of your loan — and you can still invest money in your retirement or in another investment vehicle. By putting an extra $50 or $100 each month towards your student loans, you will be paying down your interest while still being able to devote money towards your investments. You can then take advantage of the tax savings by deducting your student loan interest payments, if eligible, and continue to invest, secure in the knowledge that you are making headway on your student loan debt.
Deciding whether to pay off your student loans or invest can be a difficult choice, but it should be based on your specific financial situation, including the current interest rate for your student loans. Remember that no matter what you decide, you should continue making the minimum payments on your student loans.
Guest Post from Lauren Davidson, who is a recent graduate exploring new ways to make money to help her pay down her student loan debt. She hopes to soon start a blog to help track her journey and help borrowers in similar situations. Learn more about her at her website here.