After you’ve paid your bills and covered the necessary expenses each month, you may have some money left over. While it’s tempting to splurge, it’s usually best 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 use all the extra funds to pay off these loans. However, as a general rule, investing is a better option to explore when you can reasonably expect a return that exceeds the interest rate on your student loan.
Early repayment of student loans vs. investment: points to remember
- It is important to make the minimum payments required on your student loans.
- Prepaying student loans early might be a good idea if you have a high interest rate.
- Consider investing if you have a potentially high rate of return or if you are participating in a loan cancellation program.
Factors to Consider When Deciding to Pay Down Student Loans or Invest
If you have extra cash at the end of the month, should you pay off your student loans or invest? In short, there is no right answer. A lot of things go into this decision – like your expected return and your personal priorities. Here’s what to think about when considering whether to pay off student loans or invest.
Start by thinking about your overall financial situation. You need to consider your other debts, your savings goals, and your personal priorities. Here are some other goals you might decide to prioritize:
- Save for emergencies: Build your savings – in particular your emergency fund – should be your first priority, as this can help keep you afloat in a financial emergency. So before you pay off student loans or invest, save at least a month of spending. Over time, try to rack up up to six months of spending.
- Saving for retirement: It’s always a good idea to start your nest egg early and give it plenty of time to grow. If your employer offers a 401 (k) match, enjoy. Explore other opportunities outside of a 401 (k) to start contributing to retirement accounts and save for retirement.
- Pay off high interest debt: Credit card balances, personal loans and other types of debt may have higher interest rates than your student loans or your return on your investment. Paying them off first can give you a higher return than investments or student loans.
- Tackle Life’s Big Goals: If you are looking to have children or save for a house down payment, you may decide to make minimum payments on your debt and not invest just yet. This gives you space in your budget to save for those bigger financial steps.
One final personal priority that you need to think about is whether getting rid of your debt is a top priority for you. If so, you may want to put your investments on hold and devote all your excess funds to prepaying your student loans.
Depending on when you borrowed the money, interest rate on federal loans vary from about 3 percent to 7 percent. The interest rates for private student loans are generally higher. Paying off your debt is like a guaranteed return, so if your student loan interest rate is 5%, you get a 5% return.
Compare this rate of return to your expected investment return. Money market accounts and certificates of deposit generally obtain a low yield, of the order of 0.5 to 2%. Stocks can offer a much higher return, around 10% per year in a strong economy, but they are more volatile. A prudent but realistic return on investment is around 6-7% per year.
If the interest rate on your student loan is lower than what you can actually expect to earn by investing, then it might be a good idea to prioritize investing over prepaying student loans. It is worth noting that until Sep 30, 2021, all federal student loans have an interest rate of 0% and payments are not required. Now is the time to start investing.
Video: How a teacher paid off $ 40,000 in student loans in 18 months (CNBC)
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When you pay off student loans, you may be able to deduct the interest you pay on that debt. Eligible borrowers can lower their taxable income up to $ 2,500, which helps offset the cost of student loans over time.
If you have federal student loans, you may be able to get a student loan forgiveness, which will eventually write off some or all of your student loan debt. If you plan to take advantage of student loan forgiveness, it may not make sense to assign additional payments to debt, as making additional payments will not get you loan forgiveness any faster. Instead, you could spend the extra money investing and growing your money over time.
But look carefully at the details of the loan forgiveness. When you sign up for income-based repayment plans, such as Pay as you earn (PAYE), you might pay more interest because the loan terms extend over several years. This may affect your decision to sign up for one of these programs or to start investing now.
Paying off student loans vs investing
There is no definitive answer as to when is the best time to prepay student loans or invest. However, consider a few scenarios where one option might be better than the other.
When to repay student loans
- Your main goal is to free yourself from your debts: If being debt free is a priority for you, it makes sense to put all of your extra money into paying off your loans. Sometimes knowing that the burden of your loans will be gone is enough to be worth it.
- Your loans have a high interest rate: A higher interest rate (closer to 7% or more) on your student loans means that you are likely to get as good a return on your investment for paying off your loans as you would with an investment.
- You have no additional funds after setting your financial goals and budget: If your cash flow is unpredictable and you usually only have the minimum amount for your minimum student loan payments, it’s best not to invest.
When to invest
- The rate of return on the investment is higher than the interest rate on your loans: While investing never offers a guaranteed return, if your research shows that the rate of return on your investments is likely to be higher than the interest rate on your loans, it might be a good idea to start investing.
- You are enrolled in a student loan forgiveness plan: When your loans are canceled after a certain period of time, it might not make sense to repay as much as you can. Make the minimum required payments and use your remaining money to start investing.
How To Invest When You Have Student Loan Debt
If you’ve decided to start investing, start by figuring out how much you can invest each month to meet that goal while still paying off your student loan. Add up your monthly expenses (including some spending money) and subtract that amount from your monthly after-tax income. What’s left is a fair game for investing. Here are a few ways to try investing:
- Use an investment app: Some applications, such as Hideout or Tassels, leave you start investing with as little as $ 5. They are great for people who are new to investing or who need a little help managing their investments.
- Hire a broker: A stock broker is a person or business that buys and sells stocks on your behalf. You may decide to look for low cost online brokers, like loyalty, or opt for a free service like Robin Hood.
- Buying an S&P 500 index fund: A S&P Index Fund owns shares of all stocks in the index, which helps you diversify your investment and achieve less volatile returns.
The bottom line
The decision to pay off student loans or invest depends on your financial priorities and which option gives you the best return. If the rate of return on the investment is greater than the interest on your student loan, you may decide to invest – but keep making minimum payments on your student loans in the meantime.