Paying off loans or retirement savings
Should I save for retirement or pay off student loans?
This is a question that I have been asked a lot. Yesterday a reader (Megan) left a comment…
“Hi Bob. I have a question for you. I am a recent grad who had a job and a retirement account during the two years of post-college to starting grad school. Now I’m just starting grad school with student loans and I wanted to find out if it’s best to stop adding to it until I graduate.”
I kind of touched on this in a post I wrote about financial advice for newlyweds.
In the post I was talking about our decision to continue funding our retirement accounts while paying down our debt. I said…
“…I have come to understand the impact that time has over investments. Without getting into too much detail, I will just say that getting started investing early puts you at a high advantage. It is not just a little bit better than waiting, but a HUGE amount better. Having enough for retirement can be a breeze if you get started while in your 20’s. It was for this reason that I wanted to get the ball rolling with my investment portfolio.”
401k’s, Roth IRA’s, and student loans
My student loans were locked in at about 3%, but I don’t think rates that good are available today. I assume a 10% return on my retirement savings, so even if you are paying 5% on your student loans and earning 10% (or even 6%) you still come out ahead. Mathematically, this seems to be the much stronger answer. However, Dave Ramsey’s method -based on our behaviors rather than math - would eliminate any and all debts before investing for retirement.
Personally, if it were me, and I could get 5% or better on my student loans I would be funding an Index Fund within my retirement accounts (401k and Roth IRA). But, at the same time I really hate debt and try to avoid it at all costs.
Do you have any suggestions for Megan? What would/did you do?
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I would much rather clear my debts before I start investing. Financially, for me it makes sense as the interest on the debt is much higher than I could get on an investment. however, my husband is paying into a pension scheme with his work as they are matching his payments which is a very good deal. I am investing some money with the hope that it will increase in value and I can use it to pay off the remainder of my mortgage in a few years time. We will have to see whether it pays off.
@Rachel
I don’t know how you are investing it, but an S&P 500 index fund should give you a better return than the rate you are paying on your mortgage. Then in 10 years you can use that gain to pay off your mortgage.
I recently graduated grad school with student loans. My plan is to use all my extra money to pay off the student loans as fast as possible. Then I can take all that money and start investing for retirement. Getting those loans paid off as quickly as possible not only saves you tons of money on interest, but also frees you up to save for retirement.
Rachel,
Do you have any non deductible debt? If so, the goal should be to pay that off not your home. Your home is your largest tax deduction. What deductions will you have at retirement? What bracket will you be in? Funding gov’t controlled retirement programs will have you paying more taxes in retirement, better to pay the taxes now and use that money to put into a side account that you can borrow and pay back from without penalties and taxes. It can be accessed anytime, offers guarantees and is protected against death and disability. You can use it to finance cars, and other large purchases and supplement your retirmenet taxFREE!!!
I totally agree with the suggestion of saving now as opposed to focusing on paying down your loans faster. Especially if the rates are low. Here’s how I look at things. Savings allow you to build security. If you put chunks of money on that loan and one month you can’t make the payment,then what? If you have savings it will allow you to make that short term payment. That’s why I don’t believe in paying extra on your home. Why not pay the bank as little as possible, for as long as possible and let your money grow. At retirement pay the last bit off or not and live of your savings. All the while if you are out of a job during those years your savings will allow you to make your payments.
I would definitely play it by the number. In most cases, it make sense to pay only the minimum amount on student loans and invest the difference. Here are three reasons:
1. Interest rates on student loans are usually lower than the longer term rate of return for equity investment — i.e., SP500
2. Interest payments for student loans could be tax deductible.
3. If your employer provides matching contribution, it’s a no brainer to contribute at least up to the maximum matching amount.
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I just graduated two months ago. My fixed rate loans are at about 7% and my one variable rate loan just dropped from 7.2% to 4.2% as of July 1st. It really depends on when you got your loans and what the rates ended up at. (also if and when you consolidated) If the recent rate drop is any indication, good rates may be coming again, but I think a lot of more recent grads will be stuck with the higher 6-7% rates. In that case, it’s more of a gamble whether you can beat that rate in the market.
Personally, I currently contribute a few percents over my employer match to my 401k, a bit to my Roth IRA, a small amount to a nonretirement investment, a bit to build up my emergency fund and channel the rest to debt repayment (usually between 25-50% of my income). I plan to be debt free in 4 years or less after factoring in the cost of a replacement car.