Should you pay off your student loans faster and then save or vice versa? Use these six tips to determine which course of action best suits you. This discussion assumes you have excess cash available after making the minimum student loan payments.
These tips also work for other debt you want to repay faster, such as a home mortgage, credit card, or car loan. Hopefully you also have a least two to three months of living expenses in your checking account for emergencies. This basic emergency fund allows you to weather any short financial storm such as a medical emergency or a car accident without throwing off your entire financial plan.
1. Contribute to Your Employer Retirement Plan to Obtain their Matching Funds
Many employers offer to match any contributions you make to the employer-provided retirement plan such as a 401k or 403B plan. If you contribute 4% of your salary, for example, the employer will match that amount and also contribute 4% to your retirement account.
Failing to make this matching contribution means you have accepted a pay cut because you are not receiving your full salary.
In addition, you will pay fewer taxes now because your contributions to an employer retirement plan are made with pre-tax dollars. Thus, your annual income tax bill will be lower.
This tip is the more important than paying down debt due to the power of investment compounding. Compounding is the snowball effect that happens when your earnings generate even more earnings. You receive interest not only on your original investment, but also on any interest, dividends, and capital gains that accumulate—so your money can grow faster and faster as the years roll on.
This dynamic is particularly evident in retirement accounts, where contributions are allowed to grow for years tax-deferred or even tax-free. For example, if you start with $100 and, over the course of a year, you earn a 5% rate of return, at the end of the first year, you’ll have $105. If you leave that money alone, and the next year you also earn a 5% rate of return, you’ll have $110.25 at the end of year two. At this rate, your original investment is doubled in less than 15 years.
Compounding, and compounding of employer matching funds, is a powerful effect that should be harnessed as soon as possible. So if you have extra cash, make sure you are contributing enough to get your employer match before repaying off any loan sooner.
2. Pay Off Loans Whose Interest Rate is Greater than the Investment Earnings Rate
To really understand your student loans, you must make an inventory of them. Order them from highest interest rate to the lowest interest rate.
Now look at the expected earnings rate for any money you would be saving instead of paying off a loan faster than the minimum payment. If you are saving in a retirement account and using a 80% stock and 20% bond asset allocation, the historical annual earnings rate has averaged 6.8% from 1955-2014 (source: Vanguard). A 50% stock / 50% bond portfolio has returned 5.6% over the same period. Certificates of deposits (CDs) are averaging between 1% and 2% interest for CDs maturing between one and five years.
If you are saving for retirement and using an allocation of 80% stocks and 20% bonds and your student loans are at 6.2%, it makes sense to save the money for retirement rather than to pay off the loan faster.
On the other hand, it makes more sense to pay the loan off first if you are going to put the money in a CD earning 1.25% and you still are paying 6.2% on the loan.
3. Free Up Capacity for Other Debt Payments
You may want to pay some of the loans off more quickly to free up monthly cash flow for a home mortgage payment if you are thinking of purchasing a home. Mortgage lenders generally don’t want to have more than 28% of your monthly gross income go to home mortgage payments. And they don’t want to see more than 36% of your monthly income going to total debt payments.
It makes sense to eliminate some of the high-rate loans if it will free up monthly cash flow so that your total debt burden is lower than 36% of gross income. Remember to pay the loans off with the highest interest rate first rather than having the extra payment spread across all of your student loans. See these tips on how to use a snowball approach to pay down the loans sequentially.
4. Make Minimum Payments if You Are in Public Service
Are you employed in the public sector? If so, you could be eligible for the Public Service Loan Forgiveness Program for your federal student loans. You may want to contribute more to your employer retirement plan rather than repaying the student loans faster.
In this program, your federal student loans could be forgiven after 10 years of on-time payments. However, to be in the program you have to be enrolled in an income-driven student loan repayment plan. These income-driven repayment plans calculate your maximum payment as a percentage of your Adjusted Gross Income. You will lower your AGI by contributing to your employer retirement plan. As a result, your student loan repayment amount will be lower. Also, if you are in the program, it doesn’t make sense to prepay the loan if the loans will be forgiven.
5. Pay Off Interest About to Capitalized
Capitalization occurs when you have deferred interest on your student loans while you are in school. The deferred interest is added to your outstanding loan balance right before you start repayment. When you start repayment you will be paying interest on interest. This is the same theory of compounding described above, but it works in the lender’s favor not yours! So if you have extra cash available before the capitalization occurs, repay the capitalized amount rather than saving it.
6. Are you Feeling Discouraged by the Amount of Debt?
If you are feeling down because of your student loan burden, it may be better for your emotional well-being to pay off one or two of the loans to get the sense of accomplishment. Eliminating debt is a powerful feeling!
Remember it is not all or nothing in terms of when to pay off loans faster or to save. You can combine approaches by obtaining your employer match and paying off one high-interest rate loan. When the highest interest rate loan is repaid, you can increase savings amount. The key is to have a plan to understand how best to pay off your student loans faster or save more.