For some, finishing college is a new beginning. It’s a new chapter in life filled with opportunity. For others, college didn’t work out and opportunity took on a different name called obligation.
No matter which path you ended up on, you probably have student loans. In fact, since you’re reading this article, I would say it’s almost certain.
Fast-forward and you now have new employment which is bringing in recurring payments into your bank account. You are looking at the money in your account and trying to decide what to do with it!
When people find out that I have a passion for investing, they often ask me, “Should I invest or pay off student loans?”
If you have loans greater than 7%, then focus on paying those off first. Otherwise, starting to invest may be the better use of extra capital. Prioritize starting a 401k if an employer matches contributions to maximize your returns.
Although, that’s a simplistic answer, continue reading to help you decide based on more factors which is right for you!
What is the Average Interest Rate for Student Loans?
The average rate of federal student loans is around 5.7% according to debt.org. Private loans can even range up to a whopping 15% but the average private student loan is about 9.95%
Action Step: Now that you know the average, determine what the interest is for your loan or loans if you have more than one and write them down somewhere.
How Much Will I Pay in Interest Over the Lifetime of My Student Loan?
The common loan-term that is always referenced is 10 years. This is the standard Federal Student Loan term. One thing that isn’t taken into account is private loan companies.
While some private student loans are on a 10-year payment schedule, others are not!
Some range between 5-15 years and there are even banks that allow a more flexible payment schedule out to 25 years. Why does this matter?
Every year that you have a loan balance, you are paying interest. As we showed above, some loans can charge up to 15% annually on loan balances.
Assuming, you have a $10,000 ten-year loan, your total payments may look something like this:
If you want to see how much your payments would be by entering your own data, download a simple loan payment app. There are loads to choose from. The one I used looks like this in the Apple Store:
Action Step: Determine the length of your loan based on your current payment plan. Any statement should have that.
Action Step: Determine how much you will be paying over the lifetime of your loan. The chart above is an illustration but you can find your exact amount by looking at a statement, contacting your lender, or plugging the data into a loan payment app.
How Much Can I Make From Investing?
The is dependent on three things:
- Your original investment amount
- Frequency of contributions
- Performance of your investment
If you are investing $100, you will obviously make a lot less than if you had invested $1000. Your starting balance in your investment will have a meaningful effect on projecting what you can hope to achieve by investing.
If you put a lump sum of $1000 into an investing account, you may make some money but if you invest the $1000 and then contribute $100, you will make much more as well.
Lastly, depending on how long you allow your investment to mature and earn interest will determine how much you will make by investing.
Historically, the stock market has an annual return between 7-8% from 1921 to the present.
Using the power of compound interest, it’s easy to see how 7% on the low end can grow rapidly. Here’s
an example of what investing $100 a month for 25 years would look like if the average return was 8%.
Action Step: Determine what you would expect to make on average each year by investing. Choose 8% as a market average or use choose a rate based on your own experience or favorite stock picking service. Write it down!
Should You Invest or Pay Off Student Loans?
Finally, we’re getting to the real reason you are here. Which should you focus on first? A rule of thumb that most financial advisors give is to focus on paying off loans that have a higher interest rate than what you expect to make in your investment.
For example, if you think you can make an average return of 8%, pay off loans that are greater than 8% first, and then focus on investing.
For loans with an interest rate less than your expected 8% return can be paid with your normal payments over time.
Another thing to consider though is that we’ve been talking about historical averages for investing potential. That means, some years offer better returns while others offer less and sometimes even losses!
If you are the type of person that likes a sure thing rather than speculating on what may or may not happen, focus on the debt. Those student loan interest rates are not average, they are constant.
Every year you have a student loan balance, you will lose a set amount of money based on the remaining balance.
Investing in a 401(k) vs Paying Down Student Loans
This deserves its own section because it’s a more specific question. Do you have an employer that offers a 401(k) program with matching contributions?
If so, I would almost always choose to set up a 401(k) to at least contribute up to the percentage matched by an employer. If your employer matches up to 3% of your income, and let’s say your salary is $40,000/ year, that comes out to about $1200/year or $100 month.
By not setting that up, you are effectively preventing your employer from handing you an extra $100 each month. That’s a guaranteed 3% investment each year before you factor in market averages and the rest.
In this case, I would set up at least the minimum amount to get the maximum contribution from the employer and then focus on the higher-interest student loans.
I Paid Off the Higher Interest Student Loans, Now What?
If you just paid off your high-interest student loans, consider investing that money rather than just letting it sit in your checking account. If you had a $100 payment going to your loan, that’s $100 you can now employ into either paying down the rest of your student loans or investing.
We saw above what that extra $100/month contribution looks like when you invest it over time.
I would recommend investing it but if you just hate debt and want to eliminate it faster, then go with your gut and apply it to the lower interest balances! After all, it’s your money and you have to feel good about your decision.
Did You Decide to Pay Off Student Loans or Invest?
After reading the case for both investing and paying off student loans, which direction do you want to take? Once you decide, you’ll need to plan your way forward!
I Would Rather Pay Off Student Loans First
Great, then hopefully you wrote down all of your loan information such as payments, interest rates, and balances.
Next, you can choose to pay them down in two orders. I’ll leave it up to you which way you think will work better for you.
- Start from smallest to biggest. The benefit of doing it this way is that you will feel the wins much quicker. Your smaller balances will fall the fastest and you will enjoy the benefit of watching debts fall away one at a time in the fastest manner.
- Start from highest to lowest interest. This goes more in line with the spirit of this article since that’s why we decided to pay off the loans faster in the first place. This will save you the most money down the line.
Option 1 is more for those that benefit from a psychological and emotional response found in achieving wins. Option 2 is more for the mathematical and logic-driven patrons that just can’t ignore the numbers.
I Would Rather Start Investing
There’s no shame in that! You agreed to a loan term when you took the loan so if you want to just stay on course but start investing, that is alright too!
I would recommend investing in a retirement account before any other type of investing. Too many people fail to start investing in their older selves early on in life.
When it’s closer to retirement they wish they had invested earlier and taken advantage of those lost years’ worth of compound interest.
If you want to start investing, I’d highly encourage you to read our article on developing an investment plan.
Now that you’ve decided whether it’s better to invest or pay off student loans first, I hope you take action! If you found this helpful, consider leaving a comment or sharing it with others!