Pay Off Student Loans or Save for Retirement?

Today it’s not uncommon for college graduates to owe $50,000, $100,000 or even $150,000 in student loans upon graduating.  Unfortunately, it’s commonplace given the escalating costs of tuition and students taking more than four years to complete their education.

Students loans are the necessary price to pay for opportunities and the possibility of career advancement.  But be warned, once you assume these loans it becomes your responsibility to manage them effectively and “do your homework.”

If you’re like most of us, you didn’t hesitate to take out loans your first year of college because you were filled with the optimism that a college degree would provide you with more than enough income to meet your living expenses, save for retirement, and quickly pay off your loans.  But reality isn’t always so kind.  Now you realize that between taxes and inflating living expenses there’s not as much money to spread between paying bills and saving for retirement as you had thought.  You’re faced with a decision.  With your limited income, should you pay off your students loans or save for retirement?

If this isn’t a question you’re asking yourself, it should be.  You know that your loans won’t repay themselves, but at the same time you need to maintain a lifestyle and try to put some money away for retirement.   There’s just not enough money to go around and the question becomes one of balance, and finding out where every dollar of your income will be put to its best use.

You have three options:
Option 1: Pay off your student loans now and save for retirement later.
Option 2: Save for retirement now and make only the minimum student loan payment required.
Option 3: A combination of paying off your student loans and saving for retirement at the same time.

Though always painful to watch your money go, the decision between the three options is easy and comes down to pure math.

Review each option to decide what’s right.

Let’s review each option so you can decide which is right for you.

Option 1: Pay off student loans now and save for retirement later.

Paying off students loans before starting to save for retirement is a common mistake a lot of college grads make. The reason is simple. When they took out their large student loans a few years ago they convinced themselves the debt would only be temporary and would be paid off within the first few years after college. In other words, their goal was to erase the loans and forget they ever happened ASAP. I know this mindset because it was mine not too long ago. Another popular reason college grads decide to pay off student loans first and save for retirement later is because they want to get out of debt before saving for retirement. This is very idealistic and not very practical. If Americans waited until they had no more debt to begin saving for retirement no one would be able to retire!

But, there is a time when it makes sense to pay off student loans immediately and save for retirement later.  This is a smart decision when your student loans are charging interest greater than 8%.  The long-term investment return on the stock market is roughly 8%, so if you’re paying more in interest than you’re earning on your investments, your money is best used paying off your high interest loans first and investing in retirement later (but not too much later).  If you have multiple student loans with multiple interest rates, only pay off your over-8% loans first and put any excess money towards retirement.

Option 2: Save for retirement now and make only the minimum student loan payment required.

You should consider this strategy if the interest rate on your student loans is less than 8%. If the stock market returns 8% over the long run, and the interest rate you’re paying on your student loans is less than 8%, then your money is best used being invested for retirement rather than paying off your student loans. And when you factor in the benefits of tax deferred growth provided by retirement plans, it makes an even stronger case that you should invest your money for retirement and make only the minimum student loan payment.

Option 3: The compromise: A combination of paying off your student loans and saving for retirement at the same time.

Remember, all things in moderation.  If your student loans have an interest rate that is between 6% and 8%, you may want to consider a compromise between paying off your student loans and saving for retirement.

Example: Your $30,000 student loan (at 6.5% interest) requires you to make a minimum monthly payment of $200.  You find that after you make the minimum monthly payment and pay your other bills, you still have $100 left over from your paycheck at the end of each month.  You should consider putting an additional $50 towards paying off your student loan (because the interest rate is between 6% – 8%), and put the other $50 into your retirement account.

You’re also allowed a small tax deduction for interest accrued on your student loans if your income is under $55,000 (single) or $110,000 (married), which provides an additional benefit.

Final words of caution…

For your student loans (unlike other debt), if you can prove you don’t have the wherewithal to make your monthly payment, many lenders will let you temporarily put your student loan payments on hold – known as deferment or forbearance. This usually occurs if you’re facing unemployment or have high medical bills. But be careful, many times your interest will continue to accumulate during this time. You should check with your student loan provider and make sure you understand the fine print in your loans.

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