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.
Refinancing
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.
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?
Rob Berger
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Published or updated November 11, 2012.
{ 13 comments… read them below or add one }
While this was not part of the question, I too would refinance, consolidate, or do whatever it takes, to cut the interest rate being paid on those school loans. I would be looking to cut the rate in at-least half! That said, even at half the interest rate, I would still pay the debt off first, mostly because I don’ t like debt. But, @ 4%, the student loan debt would not look so bad. And @ the lower interest rate, I would pay off the loans off in 5-7 years….then he can help me out with my law school loans
He will earn alot more than 8% when he invests in his 401K. Why? Because if he is in the 25% marginal tax bracket (i.e. his highest tax bracket) his taxes will 25 cents for every $1 he contributes. So he gets an immediate return of 25%. The additional tax savings then can be used to pay his debt down quicker. So for every dollar invested into his 401k he will get 25% tax savings + 2% interest savings ($1x.25x.08) or a 27% return without making a penny on his investment.
At your current interest rate it would be hard pressed to get a guarenteed rate of return after tax that will be higher, you are also not talking about either making a lump sum investment or paying off the loan completely, you are looking for what to do with extra cash after your living expenses are covered.
The first thing you should do if you have addtional income is make sure you are contributing to your 401K, at least up to the match if your company has one, if there is a company match you get a 100% return on the money you contribute, you are 30 with no retirement savings, if you want to retire by 65 you need to start now and contribute aggressively. I would contribute beyond the match to the maximum allow which is $17k in 2012, $17.5k in 2013, you get a tax dedcution at your marginal tax bracket, so the more you make the higher the return. For example if you are in the 25% tax bracket and you contribute the full $17k you keep 100% of it in your 401k, had you not contributed at all after tax you would have $12,750 in checking account, by not contributing you lost $4,250.
You employer match is a 100% return, your total contribution is a return of your marginal tax bracket, both are higher then the student loan interest being charged so your 401k is a better investment then your student loan. The student loan would be where I would concentrate on applying the remainder of your extra cash, I would try to consolidate or refi the student loans money is cheap right now you should be able to get at least 2% if not more off your current rates.
did you not read the article? he specifically said no employer match, and that is what your entire comment is about.
did you not read the article? he specifically said no employer match, and that is what your entire comment is about.
Depending on your particular degree (medical, law) there are programs in which you can get your school loan debt “forgiven” by working in areas that are distressed. I think with that kind of debt, I’d look into a program like that. It could be practicing medicine in Appalachia, being an attorney in a poor area of LA, etc..
Depending on your particular degree (medical, law) there are programs in which you can get your school loan debt “forgiven” by working in areas that are distressed. I think with that kind of debt, I’d look into a program like that. It could be practicing medicine in Appalachia, being an attorney in a poor area of LA, etc..
Hello
If you invest in a 401k just a little bit each paycheck then in 10 years you have a good portion already started and use that as your budget. for example for the next year you are making $5000 a month at your job with investing a portion of that and pay your loans and bills at the same time then in the up coming years when you get a raise or a bonus you can invest more. that way no matter what you still have investing and paying the loans off as every year comes around i would try to refiance or consolidate the loans and get the interest rate down and that will save you quite a bit of money
make sure you have your emergency fund ….
The problem with investing is there is NO guarantee of a positive rate of return. The problem with being an employee is there is NO guarantee of keeping your position. Unless you are uniquely skilled in a high demand occupation, your livelihood is always at risk. If you became disabled (by whatever means), you would probably not be able to pay this debt; most DI policies (if you have one; if not get one a.s.a.p.) would not provide enough income to cover this debt. Consequently, your credit score gets trashed. If this debt means you have a high debt to income ratio (>37%) it may limit you ability to acquire a mortgage – if you ever want to buy a home. If you have another person (now or in the future), that you hope to spend your life with, having a mountain of debt rarely helps a relationship. Hopefully, you haven’t consolidated your student loans. By attacking the loans individually (highest rate, lowest balance, etc.) you should be able to reduce not only your total balance, but the minimum “required” payment as well as you pay off a loan. Thereby you will be better positioned to respond to unexpected events in life that impact cash flow. Debt is bondage – free yourself.
You finished Grad School, you owe $180,000 at 8% and you’re 30? You don’t need advice, you need a magic lamp.
180K is definitely a lot! Although paying it off and essentially getting an 8% return is technically the best thing to do. I still think that setting up an automated investing means even if its only for $100 per month while the balance goes to debt repayment is the best option.
He has a lot of debt. He is in need of finding sources of income in order to shorten the payment period. Paying the dept is the priority but if he can manage or have some extra he should try investing as well in order to catch up for lost times.
Hey, you used to write excellent posts, but the last few posts have been kinda boring… I miss your super articles. Past few posts are just a little bit out of track!