Over the last few weeks I’ve gotten quite a few questions from individuals ready to graduate college and start embarking on their first job. As is often the case, many of these individuals have varying amounts of student debt but also understand the importance of saving for retirement. Naturally, a common question is should they pay off student loans or save for retirement. Here’s my take.
As I’ve mentioned in previous posts, there are few ways to receive guaranteed returns. One of those ways is by paying down debt. This is an example of a guaranteed rate of return that is also risk free. By paying off a loan early, the interest that would have normally gone to the lender ends up in your own pocket. The good news is that the debt is retired faster, and the individual experienced zero volatility exposure compared to investing in the market.
On the other hand, what opportunity cost is the individual giving up by not investing in the market and allowing gains, dividends and interest a chance to compound over time? It’s true that the earlier an individual starts to save the more chance he or she has to take advantage of time in the market and the miracle of compound interest. We’ve all seen the examples of the difference between an individual that started investing early versus an individual getting a late start. In most cases the early investor comes out ahead.
Here are some things to consider if you find yourself in a similar situation. The first thing to do is assess your risk tolerance. In other words, are you capable of tolerating the market volatility (risk) that comes with investing outside of a risk free return? If so, investing in the market may be something to consider. In addition, are you certain you can get a higher rate of return than the interest rate on your student loan? For example, if you have a student loan interest rate of 6.8% what are your chances of getting a return higher than 6.8% in the market? The odds may be in your favor in any given year and over longer time periods, but the odds of losing money also need to be considered (and you will lose money). Paying down this debt early guarantees you 6.8% return without risk. That’s hard to beat.
Additionally, where do you plan on investing? For example, will you be investing in your employer’s 401k? Does the 401k have a match? If you have access to a 401k and your employer provides matching contributions, I would recommend saving to your 401k to the point where you receive the full matching contribution. Consider the match free money – risk free money; another rarity when investing. Once you’ve committed to saving enough to take advantage of the full employer match, consider paying extra to your student loans.
After a while, your student loans will be paid off. Good for you! However, you will have a monthly loan payment that you’ve been budgeting for quite some time. Consider keeping this monthly amount as part of your budget, and still treat it like a bill that’s due every month. Only now, you’re going to pay yourself. The good news is that you’ve already budgeted for it, but now you’re simply allocating that money to your 401k or IRA.
If you don’t have an employer match, consider saving in your 401k anyway. Aim for 15-25% of your gross income and focus on putting any extra money to your student loans. In just a short period of time, you’ll find that you’re way ahead of the game when it comes to having little to no debt and quite a bit saved for retirement. It’s simply a matter of prioritizing your money. Pay yourself first and live off of the rest.