The question I receive more than any other is whether you should pay off your debt before investing. In response to my article on paying off debt versus saving for retirement, a reader asked the following question:
I recently finished grad school with about $180k in debt, most of which is at high interest rates (7.75-8.25%). I make enough that I do not get any tax deductions for the huge amount of interest I’m paying on my loans. I can start contributing to my 401k in January (no employer match) and am trying to figure out how to split my money between paying off loans, retirement, and any other investments. Right now, my loans are set up to be paid off in 10 years, and I am making some additional payments when I can. I am 30, have no current retirement savings, no credit card debt, no mortgage (I rent), and have plenty in my emergency fund. Any advice would be greatly appreciated!
Frankly, it’s hard for me to fathom $180,000 in student loans. I finished law school with $55,000 in debt. Of course, that was 20 years ago. But given his debt and with an interest rate of about 8%, he’s paying more than $2,100 a month to service his debt. That’s a lot of dough.
So should he pay off his student loans before investing for retirement? Here are some things to consider.
Paying Off Debt Is Investing
While we don’t think of it as investing, paying off debt accomplishes the same thing. Remember that your net worth is calculated as assets minus liabilities. You increase your net worth by increasing your assets (e.g., saving money), decreasing your liabilities (e.g., paying down debt), or both.
In this case, paying about 8% interest today is steep. You’d need to earn 10% or more before taxes to equal the savings you’d enjoy by paying off debt that costs 8%. And paying off the debt offers a guaranteed return. So as the reader pays down his debt, his net worth goes up and the amount he pays in interest goes down.
Although not part of his question, I’d look at ways to lower the interest rate on the debt. Refinancing to a lower rate is the easiest way to save a ton of money, whether you are refinancing a mortgage, a car loan, or student debt. Not only does refinancing reduce the amount of interest you pay, but it can also speed up the time it takes to pay off the debt.
A great place to look for refinancing options is Credible. This website searches multiple lenders at one time to help you find great rates and terms.
So Should He Invest Now?
It’s important to keep in mind that most personal finance questions are not all or nothing. If the reader has the money, he can both pay some extra on his school loans and begin saving some for retirement. The question is should he.
I think he should focus on his debt first. Why? Two reasons. First, his employer doesn’t match 401(k) contributions. If he did get a matching contribution, I’d have a different view. Second, the interest rate on his school loans is high. It’s not double-digit credit card interest high, but it’s high. If he can refinance the debt and lower the interest rate, then investing some now may make more sense. But with interest at 8%, I’d be focusing all of my extra cash on the debt.
So what do you think? Should he begin investing now or focus entirely on his debt?