Should I Pay Off Student Loan Debt or Invest?

This will be the first in a series of basic investing posts. As I think about where I want to go with the website, I realize that I should answer the questions I had when I started out and share what I have learned in the process.

One of the biggest dilemmas I ran into personally was the question of whether it was best to use excess cash to pay down my student loan debt, or invest in the stock market (and by “stock market”, I of course mean index funds – not individual stocks or managed funds). This same question could be asked with medical debt, credit card debt, a car loan, or possibly even a mortgage.

I am here to report that there is no perfect answer. I think there are good arguments for both sides. As I tossed this idea around, my ultimate answer was to do both. Invest in the markets, and pay down debt at the same time. Here is the order I would do things in:

1. Make The Minimum Payments on Your Student Loans

The first thing you need to do is not default on your debts. I guess this goes without saying, but start by making whatever the minimum payment is.

2. Max Out Your Tax Advantaged Retirement Accounts

I didn’t do this at first (I was trying to figure all of this stuff out), but if I knew then what I knew now, I would have started a SEP IRA the first year for my business and contributed as much as I could to it. Instead I contributed to a ROTH IRA in my first year. I could have saved some money on taxes by funding a SEP in my first year, but am glad I at least contributed to something. The advantage to contributing to a SEP IRA (or a 401K, or some other tax deferred account), is that the contributions are tax deductible so you pay less in taxes. As someone who is self employed and making money, this quickly becomes a big deal. Taxes are killer, especially for the self employed, and it makes sense to legally avoid them at all costs.

If your employer offers a 401K, I would at the very least contribute whatever it takes to get the employer match. That is “free money”. In a perfect world I’d max that sucker out.

3. Split Anything Left Over Between The Loans and a Brokerage Account

If you have made the minimum payments on your loans, have taken full advantage of your tax advantaged accounts, and still have money left over, then that is where it starts to get interesting. You could throw that extra loot towards your student loans, you could fund a non-tax advantaged brokerage account, or you could do what I did: both. I suppose you could also do something else with the money, like create an emergency fund, save up for real estate, blow the money at a strip club, etc. But for arguments sake we will just assume you want to either pay down debt or invest with this extra cash.

What makes the most sense will depend on the interest rate on your loans, whether you can take advantage of the student loan interest deduction, and your tolerance for unsecured debt.

If the interest rate is 6.8% like mine was, I would strongly advise using most of the money to pay down the debt. By paying off down the loans you get a guaranteed return of 6.8%, which is pretty excellent if you are talking about guaranteed returns. I’d take 6.8% guaranteed all day over the vagaries of the stock market.

I’d also chuck more towards the loans if you are just starting out your repayment plan. You pay more interest at the start of a loan, so by making additional payments to principal early on you both reduce the total amount of interest you will pay, and you will reduce the life of the loan. Contrast that with getting towards the tail end of a loan. In that case, you are mostly paying principal.

img-loan-amortization-chart

If your loans are at an interest rate of below 4%, the decision may become harder. I ended up refinancing my student loans about half way through repaying, and my new interest rate was around 3.7%. 6.8% made the decision easy. 3.7% gave me pause. The prevailing notion is that the S&P 500 has historically yielded an inflation adjusted return of 7%. So on average you are going to get a superior return investing in the portfolio and playing some interest rate arbitrage. Your net return will theoretically be greater if you make the minimum payments on the student loans, and shovel excess capital into a portfolio.

While the cold hard calculated answer may be to invest the difference in a portfolio, some people really don’t like unsecured debt. I don’t think you can fault those people.

Personally, I really did not like the idea of having student loan debt, so I chucked most of my excess capital to the debts. I still funded a regular brokerage account and a Lending Club account, but I probably contributed $500 a month to those accounts. On the flip side, I was funneling $2k+ a month to the loans. I paid the loans off in about 3.5 years, approximately 6.5 years early, and jumped over thousands of dollars of interest payments. The student loan interest rate deduction didn’t do much for me, as I was phased out of it, and I would go nuts every time I saw the outstanding balance on my loans.

Advantages to Paying Off Loans Early

I can think of a few advantages to paying off the loans early vs playing interest rate arbitrage, but they are more reasons for psychological health than anything. If you are very debt adverse, fiscally conservative, etc, you will likely sleep sounder locking in the guaranteed return of paying off the debt. It will shore up your balance sheet, making you more credit worthy, and once you pay off that loan it will free up cashflow.

If you go by historical rates of return it will not yield the biggest bottom line, but I am not sure most people will really notice a huge difference.

Advantages to Investing and Not Paying Off Loans Early

As previously mentioned, the main advantage to not paying off your loans is it frees up money that can be presumably invested at a greater return than the interest rate on your student loans. Thus, you net the difference in interest rates and ultimately wind up with more money at the end of the day. Some people have used this to great effect, making the minimum payments on their student loans and using their cash to buy real estate at the trough of the market. Hats off to them. If you have the ability to truly find a superior return elsewhere, then the math dictates this is the best outcome.

Also, if you were to invest money in a brokerage account you could presumably sell your positions easily and free up the cash in the event of an emergency / amazing opportunity / etc. This is called having “liquidity”. Once you pay the bank you will never get that cash back (unless of course you take out another loan). This liquidity argument can be another benefit to investing your excess cash. Of course, if the stock market takes a nose dive you aren’t going to want to cash that investment out anyways, so practically speaking I am not sure how much water this argument holds.

Consider Where You Are in Your Loan Payoff Schedule

Again, if you have just graduated and started paying your student loans, then it makes the most sense to chuck extra money at the principal. This is because when you start paying down a debt with interest, the interest is front loaded and most of your initial payments go to interest. Contrast this with getting to the end of the loan, where most of your payments go to principal.

If you are on the fence between paying off early and investing, then see how much of your payment is going to interest and how much is going to principal.

If you are already 5 years into a 10 year loan, then maybe you don’t want to be so aggressive as you have reached the tipping point and more of the payment is going to principal than interest. If you are at the very start of your loan, then now is a great time to make extra payments to minimize your interest expense.

Personally, it really pissed me off to see 75% of my payment go to interest. That was like money out the window. I wanted to throw extra at the principal to get that number down. Then again, I was pissed off at the tail end of the loan too. I’m just an angry person when it comes to unsecured debt.

Student Loans vs. Savings – Final Thoughts

While there is no perfect answer, I think utilizing tax advantaged accounts is important. If you can afford to save, you want to start saving something – especially if it benefits you from a tax perspective. The net gain will be higher, and you can never go back and claim the benefit of these tax deductions for prior tax years. Might as well carpe diem.