Don’t Rush to Pay off Your Student Loan – make a plan first

This may surprise you: you should worry more about saving for retirement than paying off your student loan. Yes, there are many bloggers testifying to how they paid off their loans, and many trying to tell you that you need to too. The frequency of such posts does not mean that they are right, or that they have factored in all that you need to for a “best use of cash flow over time” plan. In fact, paying off student loans that have relatively low interest rather than investing will be a costly mistake.

Compare student loan payoff blog posts to the many advisors who encourage paying off your mortgage. The urgency to retire your mortgage belongs to the Silent Generation, who survived the Great Depression and are risk adverse. Paying off a mortgage is usually not the way to maximize your net worth. (Watch for a post on “rent vs. buy” discussing investing and use of mortgage debt.) Furthermore, tying up so much capital in a house lacks for diversification and liquidity – you cannot sell your daughter’s room to cover tuition when she goes off to college.

How do you decide what loan to pay off when? Start with this rule:

Whenever the interest rate on debt is less than the annualized return on investments, only pay the minimum on the loans

because the investments will grow faster than using the same cash to pay off debts

The term “annualized” returns is key here, as one good year is not a good measure, nor is a recent bad year; you want the 5 or better 10 year average return.

Next, when applying this general rule to yourself, be sure to use after-tax values. You can deduct home mortgage interest in most cases, a portion of student loans in some cases, and credit card debt in almost no cases, while you can deduct your investment in your retirement plan and what you invest grows tax-free until withdrawn. Roth IRAs do not give you a deduction now, but do grow tax free and withdrawals are tax-free.

Here is a quick example: say your retirement plan is all in ETFs, so it grows at about 7% per year over time, say you have a student loan with an interest rate of 3%, because you consolidated all your undergrad loans, and it has a minimum payment of $500 per month, and say you have $1,000 per month for which you want to devise the best plan. Apply no more than the required minimum to student loan and invest all the rest, maxing out your 401(k) or 403(b) plan first, and then investing in a Roth IRA next. In 10 years, you will be so much better off than the person who used the full $1,000 to pay her student loan. What if you had a loan with an interest rate of 8%? Tough call. However, because the loan is compounding over time at a higher rate, that persuades me to apply more to the loan, provided that doing so did not give up an employer match on a 401(k) plan.

These examples are overly simple, I realize. Many of you face the quandary of student loan vs. retirement funding vs. rent or buy a home and more. I am working on that …. (Watch for a post on integrating decisions on buying a home, paying off student loans, investing for retirement and all the other issues you are likely to face.)

Investment advice on saving for retirement – now!

Start your investment plan – now! Your future portfolio will thank you

“There’s no time like the present”, especially when it comes to investing. Young adults have a great advantage over other investors: time.

Compounding – The benefit of time is that is allows for interest to compound, which is the ability of an investment to grow by reinvesting earnings. Consider that a single $10,000 investment at age 20 would grow to over $70,000 by the time the investor becomes 60 years old (based on a 5% interest rate). By comparison, the same investment made at age 30 would yield about $43,000 by age 60, and made at age 40 would yield only $26,000. The longer money is put to work, the more wealth it can generate in the future.

Matches – If your employer offers an employer-sponsored retirement plan, like a 401(k), we suggest you enroll in their plan. Not only is savings made easy through automatic payroll deductions, but your contributions are made with pre-tax dollars. Additionally, many employers offer 401(k) matches, which means they will contribute money into your account. If you don’t take advantage of this benefit, then you are leaving money on the table.

Resources – Another advantage young people have is there are now, more than ever, many low-cost services available to make saving and investing easy.

  • Consider the Acorns app. This app rounds up each transaction you make with your debit or credit card to the nearest dollar and invests the change into a diversified portfolio.
  • Robinhood is another useful resource. This app offers commission-free trading of listed stocks and ETFs. They run a lean company which allows them to operate for less. They make their money by accruing interested on investors uninvested cash balances and through fees charged in their upgraded version. This is a low-cost means of entering the investment world.
  • Check out Betterment.com, a robo-planner website for investing using ETFs that holds down fees. You use this to invest your taxable funds and your retirement plans, like IRAs.
  • Also check out earthfolio.com, a robo-planner for investing “with a social conscience.”

Whichever form of investment you decide to take, the earlier you begin, the better. Start building your wealth now! See also: Young people, don’t let this happen to you. Plan for retirement now!

 

[As we have stated in past posts, we recommend investing passively, using ETFs or index funds, so you save fees. You can buy a diverse set of ETFs, set up your portfolio and sleep until you rebalance next year.]