Pay Off College Loans or Save for Retirement?
July 8, 2015 | Your Finances
Maybe you recently got a raise. Or maybe, when you paid your monthly expenses, you realized that you have some extra cash. Should you put that money aside to boost your retirement savings, or should you use it to pay down your student loan faster than your required minimum payment?
Like many things in life, there’s no right or wrong answer here—everyone’s circumstances are different. So how do you evaluate which option is right for you?
Take a Closer Look at Your Student Loans
Start by comparing the interest rate you’re paying on your student loan with the expected returns on your retirement account.
Generally, if your loan rate is higher than your expected investment return, it may be a good idea to contribute an amount at least equal to any employer match to your retirement account and allocate any extra cash to paying off your loan. Accelerating your payments will eliminate your student loans faster, thus freeing up money for other goals.
Paying off your debt early can also help improve your credit score. A higher credit score may enable you to secure a lower interest rate down the road, should you want to borrow money for larger purchases, such as a car or a home.
What if the interest rate on your student loan is lower than your anticipated investment returns? You may want to consider making the minimum required payment on your loan and directing any extra income toward building your retirement account.
Yes, it will take you longer than you might like to pay off your student loans with this strategy, but keep in mind that you might enjoy a tax benefit along the way. That’s because the interest you pay on your student loan may be tax deductible, depending upon how much you earn.
You’ll also benefit from the tax advantages that come from saving for retirement, including the potential for tax-deductible contributions. More important, those contributions will grow tax-deferred until you withdraw them, typically in retirement.
And if you’re saving through an employer-sponsored plan and your employer offers a company match, your account value has the potential to grow that much faster. In many cases, the value of those advantages may be worth far more than the interest you might save by accelerating your student loan repayment.
The Value of Time and Money
Some people assume they can postpone saving for retirement and make up the difference later. This can be a costly mistake. Waiting even just a few years to start saving can make a significant difference in how much you may be able to accumulate.
To see how much, consider this example. Karen and Wayne are twins. Both are 22 years old and newly employed, and both of them have student loans that will need to be paid off.
Karen decides to start saving for retirement right away. She makes a budget and determines that if she makes the minimum required payment on her student loan, she can afford to contribute $250 a month ($3,000 per year) to her retirement plan. She contributes regularly to her retirement account for 10 years and then stops.
Wayne decides to focus on paying off his student loan and using whatever extra money he has each month for travel and entertainment. He figures that he will be able to catch up on saving for retirement later on, after his student loan is paid off and he has more money to invest. As a result, he waits until he is 32 to start contributing $250 a month ($3,000 a year) to his retirement plan, which he continues to do until he retires 30 years later, at age 65.
Let’s assume that Wayne and Karen both earn a 7 percent average annual return1 on their contributions.
When Karen and Wayne are 65, they compare accounts. Keep in mind that Karen contributed a total of $30,000 ($3,000 per year x 10 years) during the 10 years she participated in her retirement plan, while Wayne set aside far more: He contributed $3,000 a year x 34 years for a total of $102,000.
Even though Wayne contributed $72,000 more to his retirement plan than his sister, Karen’s nest egg ended up larger than his: $464,319 vs. $417,019.
The reason? By getting an early start saving for retirement, Karen’s money had longer to grow and compound. Over time, the value of that tax-deferred compounding made a significant difference in the amount Karen was able to accumulate for her retirement goals.
Like many other people with student loans today, you may feel a tug-of-war when it comes to allocating any extra income you may have. Paying off student loans early can be a worthy goal. However, it’s important to remember that you could be sacrificing crucial tax-deferred growth if you focus exclusively on repaying your student debt at the expense of saving for retirement.
1 This is a hypothetical interest rate used for illustrative purposes only. It is not indicative of any particular investment vehicle or strategy. All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.