For adults with student debt and extra money on hand, deciding whether to pay off student loans early or put those funds toward retirement can be tricky. It’s a financial tug-of-war between digging out from debt today and saving for the future, both of which are very important goals. This decision is relevant today considering that roughly 65% of college graduates in the class of 2018 had student debt, with an average debt of $29,200.1 This amount equates to a monthly payment of $295, based on a 4% interest rate and standard 10-year repayment term.
Let’s assume you have a $300 monthly student loan obligation. You have to pay it each month — that’s non-negotiable. But if you have extra money available, what’s the better course: pay more toward your student loans each month to pay them off faster or contribute extra funds to your retirement? The answer comes down to optimizing how those dollars can be put to work for you.
The first question to consider is whether you are taking full advantage of any 401(k) match offered by your employer. For example, let’s say your employer matches one dollar for every dollar you save in your 401(k), up to 6% of your pay. If you make $50,000 a year, 6% of your pay is $3,000. So by contributing $3,000 per year to your 401(k), or $250 per month, you will get the full employer match of $3,000. That’s a 100% return on your investment.
If you are already contributing enough to get the full match, next compare the interest rate on your debt to the rate of return you could be earning on any extra funds you invest. When you make extra payments on a specific debt, you are essentially earning a rate of return equal to the interest rate on that debt. In the student loan example, the interest rate is 4%, so by applying extra money toward that debt you are “earning” a 4% return. If you think you can earn a higher rate of return by investing extra money in your retirement account, then those funds might best be put to work for you there.
Of course, no one can predict their expected rate of return with certainty. But generally speaking, if the interest rate on your debt is relatively low, the potential long-term returns you might earn in your retirement account could outweigh the benefits of shaving a year or two off your student loans. If you have time on your side when saving for retirement, the long-term growth potential of even small amounts can make contributing to your retirement account a smart financial move.
All investing involves risk, including the possible loss of principal, and there can be no guarantee that any investing strategy will be successful.
1. The Institute for College Access and Success, 2019
Pensionmark Financial Group does not provide tax or legal advice. Please consult with a tax professional prior to deciding on any distribution option.