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Should I Pay Off My Student Loans or Invest the Money Instead?
What is the better idea: paying off your student loan debt in full or investing that money in the stock market or in real estate? You can make a case for both sides and the answer to that question really depends on your own personal situation and your personal finance goals.
The average debt load for a college graduate in 2013 was $29,400, according to a CNN report. This is a very high amount, especially for someone who is only in their twenties and just starting off their careers. Unfortunately, the debt burden is causing many young people to delay marriage, buying a house, etc. Still, it might make more sense for you to put your money to work by investing.
Invest or Pay Off Student Debt?
Here are several factors you need to consider before making a decision:
- How much total student loan debt do you have? What are your monthly payments?
- At what interest rates are your loans? You are going to want to pay off the highest interest rate debt before the lower rates.
- Do you have any other debt, especially credit card debt? Paying off credit card debt should be your top priority, since this is often the highest rate debt at over 12 percent in most cases.
- How much money in savings do you have?
- Do you have an emergency savings set up? I recommend having at least 3 months of your total monthly expenses saved up.
- Do you have a "secure" full-time job? This means that you are more than likely going to be at your current employer for the foreseeable future.
- What is your total monthly income and expenses? Are you bringing home positive "cash flow" each month? This means you should have a surplus of cash after all expenses are paid off each month.
- Do you need your savings for anything in the future or are you okay with investing that money? Are you okay with losing any of it? Remember, investing involves risk including loss of capital, so you must be okay with the possibility of losing that money.
Can I Get Rid of Student Loan Debt Without Paying for It?
Another unfortunate fact about student loans is that, in most cases, it is a debt that is not forgivable! For example, when a person goes through personal bankruptcy, most of their debts are wiped out - credit card debt, mortgage debt, etc. You get a clean slate and your credit score takes a big hit. This strengthens the case for just paying off your student loans instead of investing.
The average interest rate on student loans ranges anywhere from 3.5 % to 8.5 %, but even higher in certain cases. You should find out exactly what rate you are paying on your loans before paying anything off.
If you are lucky enough to have a good paying full-time job and if you are careful with your money - how do you decide to either use that money to pay off your student loan debt or invest the money?
Here, I will argue for both sides.
The Case for Just Paying Off Your Student Loans
Let's say you are Bob, a 25 year old with $20,000 in savings, versus $20,000 in student loan debt at an average rate of 6.5 percent. You work full-time and have a total monthly after-tax income of $3,000 versus total monthly expenses of $2,500, giving you positive cash flow of $500 a month. Bob has no credit card debt and rents his home so he has no mortgage.
You are interested in starting an investment brokerage account, but you also like the idea of paying off your student loans in full. What is the better idea?
Should Bob Pay it Off or Invest?
Bob has $20,000 debt, as mentioned, at 6.5 percent. On a 10-year loan repayment plan, Bob will end of paying $7,251 in interest on the loan, with total monthly payments $227.10.
Therefore, if Bob pays off his debt today, he will immediately save $7,251! That is a pretty sweet scenario for Bob. This will also lower Bob's total monthly expenses, from $2,500 to $2,272.90. So this scenario also drastically improves Bob's cash flow situation, allowing him to save up money faster. However, Bob will be left with little in savings, so Bob should consider not paying the amount in full just yet.
Breaking the Debt Chains
There is no doubt that if Bob just paid off his loans now, he would benefit a great deal. Having paid off most of my loans personally, I can tell you that it is an amazing feeling to rid yourself of this burden. You are able to save up money so much faster, making it easier anyway to invest your money.
So even if you don't start investing today, you will be more likely to begin doing so in the future now that you have the money freed up. That $227.10 that Bob saves each month can now go towards his investments. If Bob invests $227 in the stock market, and adds $2,500 a year for 5 years (or $208 a month), earning 7 percent a year on his money, then Bob will have $6,270 in his investment account after just 5 years!
What is the Better Option?
Paying Off Student Loans Versus Investing in Stocks?
One "Negative" To Paying off Your Loans Early - Topic 456 Student Loan Interest Deduction
There is one potential disadvantage to getting rid of your student loan debt a little early - you miss out on the tax benefits.
The IRS says that you may be able to deduct interest you pay on a qualified student loan. "Generally, the amount you may deduct is the lesser of $2,500 or the amount of interest you actually paid." Read more about the topic here.
Hypothetical Gains Since 2008
What if you started investing during the recession of 2008, when stock prices were low? The best gains are made when markets panic and sell-offs occur - this is called "Contrarian Investing" or investing against the crowd.
If you had $20,000 and starting investing in SPY in March of 2009. SPY is an ETF which generally corresponds to the price and yield performance of the S&P 500 Index. The ETF, like most other stocks, has provided investors smashing returns since 2009, returning 17.48 % a year or a total return of 97 %.
Congratulations, because your $20,000 investing now stands at nearly $40,000!
For fun, let's take it a step further and say that you started investing in a little company called Netflix in 2009, when the price per share was $30. You held the stock for the past 5 years. Well, congrats because today Netflix is worth more than $360 per share, giving you a total return of over 1,000 % on your investment! Your $20,000 investment in now worth more than $200,000!
This is why it might make sense for Bob to invest his money instead of paying off his loans early - the potential for life-changing returns. However, with that potential for reward obviously comes some risk. These returns are not typically and hard to duplicate, but they are possible!
The Case for Taking Some Risks and Investing The Money
Let's say that Bob is a risk-taker and wants to start investing his money in some small cap stocks. Remember, Bob has $20,000 in savings but also has $20,000 in student loan debt, and he has monthly income of $3,000 a month, versus $2,500 in monthly expenses.
If Bob just paid off his loans today, he would immediately gain $7,251 in not having to pay the interest over the 10-year life of the loan. So why would Bob consider investing instead?
The average gain in the stock market on average, historically, is anywhere from 7 to 10 percent. We will use an average annual return of 8 percent for this example.
So if Bob starts investing today, doesn't sell any stock and achieves an annual average return of 8 percent a year for 10 years, then Bob will have a total balance of $38,614 after 10 years. This represents a gain of $18,614 on Bob's money, for a gain of over 85 percent! These are great returns and definitely achievable in an average market.
If you look at the numbers quick, the case for investing looks stronger - Bob made more than $18,000 by investing, compared to saving $7,251 by paying the loans off early.
So, what's the catch?
Well, here's a few things you need to consider. First, Bob will have to pay taxes on his gains. The capital gains rate for long-term gains (over 1 year) is 15 percent for someone in the 25-35 percent tax bracket in the USA. So, Bob will have to pay $2,792 on his gains, dropping his total real return to $15,822. Still a lot better than the student loan savings, however.
Another thing to consider is trading fees, which range from $8 to $10 a trade. The biggest thing, however, is that investing involves the potential loss of capital and you never know when the market could tank. For example, you could make 8 percent a year on your investments, but a recession or market panic similar to what we saw in 2008 could happen at anytime. You need to understand this risk and perhaps take some money off the table if you are already sitting on big gains in the stock market.
Hypothetical Gains From Paying off Student Loans
"Gain" From Early Payoff
Monthly Payments (10 Years)
Hypothetical Stock Gains Since 2000
% Gain Since 2000
Investment Gain on $10K
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