By Joseph Reinke, CFA, CEO of FitBUX
One of the most common questions we get at FitBUX is “Should I invest or pay off my student loans?” This is a complex question because each person’s goals are different and both options have advantages as well as disadvantages.
This article will help those trying to find a starting point in regards to making this decision as well as take it one step further for those that want to dive a little deeper.
I also want to emphasize that this article is written from a “money efficiency” standpoint, i.e. what approach is the most financially beneficial in the long run. At the end of the day, the best choice is the one you understand, are comfortable with, and will implement.
Also, you can join the FitBUX Finance group on Facebook and attend our upcoming webinar on the topic scheduled for March 27. ==> Join FitBUX Finance Group
Where To Start
When making your decision, the first place to start is determining what student loan repayment plan you are going to be using.
If you will be using an Income-Driven Repayment plan (IDR) then the choice is easy: save, save, save. The reason is two-fold:
- When you select such a plan, you are going for loan forgiveness and there is no point in paying back something that will end up being forgiven anyway.
- The amount forgiven will be treated (and taxed) like regular income, so you should be saving all you can to make sure that at a minimum you can cover this future tax liability.
It gets a little more complicated if you are repaying your student loans using a standard 10-year plan or the standard extended plan. The key in this situation is looking at the interest rate on your loans.
Let’s assume you have $100,000 in student loans at 6% and that you will be repaying this loan over 10 years. Over the ten years, you will pay a total of $133,224. This figure consists of $100,000 you originally owe plus $33,224 in interest. The required monthly payment would be $1,110.
Let’s now assume that you have $100,000 in cash and repay your loans immediately instead. Since you would no longer have to make a monthly payment of $1,110, you would essentially put the $1,110 in your pocket every month. In 10 years, you would have $133,224.
In short, instead of paying your lender 6%, you paid yourself 6%. The key is the 6% you put back in your pocket is risk-free i.e. this money wasn’t invested and exposed to any kind of financial loss.
Therefore, when deciding to invest or repay your loans aggressively you have to look at the return on other risk-free investments such as savings account, certificate of deposit, and treasury bonds and see which approach yields the best return:
If those investments return less than the interest rate on your loans, then, purely from a financial perspective, it makes more sense to repay your loans rather than invest.
Not All Money Is Treated Equally
To keep things “interesting”, pre-tax retirement accounts make this decision a little more difficult.
Let’s now assume that you are trying to decide if you should contribute $4,000 to a pre-tax retirement account such as a 401k or an IRA or use that money to make prepayments on your student loans.
If you contribute the $4,000 to your tax-free retirement account, then you have 100% of that invested for you since this is a tax-free investment.
If you decide to instead use these $4,000 to prepay your student loans, you will have to pay taxes on the money first. If you are in the 25% federal tax bracket for instance and assuming your student loans have a 6% interest rate, this would mean each year you decide to use your $4,000 to repay your student loans instead of investing in your tax-free retirement account, it will cost you 19% of that amount (the 25% tax impact, partially offset by 6% you save by not having to pay interest in the long-run).
To add to this, let’s assume your company matches your $4,000 401k contribution. This would mean you would now have $8,000 invested tax-free instead of $3,000 to pay off your loans.
Long story short, at a minimum, I would highly suggest saving enough in your retirement account first to benefit from your company match if its offered to you and then, and only then, decide what you should do with your left-over money if you should continue investing or prepay your student loans.
How We Can Help
If you are trying to make this decision, let us know, we will be happy to help:
We’ve helped young professionals manage over $400 million in student loans.
We recently began testing a new service as well whereby we can help you manage your retirement funds as well. This gives us the ability to help you coordinate your savings and student loan repayment plan.
If you’d like help with your student loans or would like to help us beta test our new service please follow the following link: I Want Help
Also, if you would like to listen to a podcast on this subject, I recently joined Rachel Jermann of Talus Media to discuss. See below for the podcast: