by Erin Lowry
Fortunately, Peach’s debt came as no surprise to me. We’d gotten financially naked with each other long before marriage. But once rings went on fingers, his debt suddenly became a new force in my life. I’d been aggressively saving and investing since my early twenties, and now I wondered if that made the most sense for us as a couple. Perhaps we should funnel our financial resources toward getting debt free as quickly as possible instead.
I’ve always been debt averse, so the idea of allowing tens of thousands of dollars to weigh down our marital ledger pained me.
We started discussing our options. We could put some of the savings I’d brought into the marriage toward paying off the debt quickly. I could press Pause on investing outside of retirement and put that extra money toward paying off the debt. Peach had only been investing for retirement and otherwise put his money toward his student loans and other short-term goals. Or we could keep paying more than the minimum amount due on his student loans, so the debt would be paid off moderately quickly, and still keep investing, too.
After running the numbers, we decided to use some of our savings to immediately pay off one loan that carried a 7.75 percent interest rate. Instead of depleting a lot of our cash reserves or selling investments, we elected to pay down the remaining loans less aggressively, because of their interest rates. Upon doing the math, it made more sense to have some funds available to keep investing instead of exclusively focusing on debt repayment and pressing Pause on investing.
This plan meant I would need to push back against my psychological desire to be debt free ASAP, but it also was the best decision for our financial health as a couple.
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• • •
WHETHER TO INVEST while you’re paying off student loans is a fiercely debated topic in the personal finance world. It’s about half a step below the “Should you be allowed to splurge on nonessentials when you have debt?” debate. (I vote yes, with moderation.)
Truthfully, the answer is simple: yes, you should be investing when you have student loans.
You’ll need to buckle up for some actual number crunching in this chapter. It’s the only way to make a compelling case for why it’s in your best interest to start investing before paying off student loans.
STEP ONE: DO THE MATH ON YOUR INTEREST RATES
There’s a significant difference between investing when you’re carrying student loan debt and investing when you have credit card debt, also referred to as consumer debt. Your credit card debts probably carry annual percentage rates (or APRs) of 15 to 30 percent. You’re not likely to see average returns like that on all your investments from the market in a year and certainly not on average over a longer period of time. Therefore, it doesn’t make sense for you to focus on investing when you have a debt accruing 15 to 30 percent in interest, because even with strong market returns, you’d still be losing money.
I’ll break it down with actual numbers.
Paying Off Credit Card Debt vs. Investing
Let’s say you invested $3,000 in an S&P 500 index fund, and it earned an 8 percent return for two years. Great! You’ve earned $499.20 by simply investing. But at the same time, you were carrying $3,000 in credit card debt at a 22 percent APR and paying the minimum $120 a month. It would take you thirty-four months to pay off the credit card debt and would cost you over $1,000 in interest. You may have earned $499.20 by having $3,000 invested in the market, but the $499.20 you earned investing minus the $1,000 you paid in interest on your credit card debt means you really lost over $500 by not redirecting that money toward paying off consumer debt.
You might be thinking to yourself, “Wait! You just told me I should still be investing if I have debt.” That’s because student loans and credit cards aren’t the same. So, before you freak out and stop contributing to your retirement accounts and start throwing every spare penny toward student loans, let’s consider a similar scenario with student loans.
Paying Off Student Loan Debt vs. Investing
Let’s say Olivia took out $11,000 in direct unsubsidized federal student loans carrying an interest rate of 4.66 percent.1 She also has $7,000 in student loans from Discover with a fixed rate of 6.50 percent. Between the two, her average interest rate is 5.58 percent. Olivia is required to pay $196 a month, but pays an extra $54 to make the payment an even $250. So, to review, that’s:
$18,000 in student loans
Average interest rate: 5.58 percent
Monthly payment required: $196
Olivia pays: $250
To get a better sense of Olivia’s monthly budget, you should know that she contributes to her employer-sponsored 401(k) program, puts money into savings, pays all her bills, and puts money aside for her general monthly living expenses, including entertainment. After all that, she still has an extra $200 a month. Her financial oxygen mask is fully affixed.
Even though Olivia is paying above the minimum due on her student loans, she isn’t fixated on aggressively paying off her debt. She wants to buy a house in about ten years, so she’s interested in making her money do some of the work, so she decides to put the extra $200 a month into an S&P 500 index fund.
Now we’re going to fast-forward eight years. Olivia’s paid off her student loans. The extra $54 a month in payments helped her reduce her loan repayment period from ten years to just over seven. She forked over $3,969 in interest on top of the $18,000 principal balance owed.2
If Olivia had put the extra $200 a month toward her student loans instead of investing it, she would’ve paid off her debt in just under four years and spent approximately $2,000 on interest instead of the $3,969 she paid. That’s nearly $2,000 she could’ve saved on interest, not to mention being done with payments in about half the time. She’d also have $450 freed up per month to put toward saving for her down payment.
If Olivia chose not to pay off the debt quickly and invested instead, after eight years of consistently putting $200 a month into an S&P 500 index fund, she invested a total of $19,200, which earned an average 7 percent return over those eight years. Her grand total in the account is currently $24,623.53. That’s a return of $5,423.53. Not a bad return, but there are three things to consider. First, Olivia paid nearly $2,000 more in interest by not paying off her student loans aggressively with her extra $200. After subtracting that $2,000, her return is still up about $3,500 from investing, but she probably wouldn’t have invested for all eight years because . . . Second, if Olivia wanted to stay on the time horizon of buying a home in ten years, then she would’ve needed to move her investments to a more conservative investment around year 5. That would’ve resulted in a portfolio of $13,800 and a return of only $1,800. Third, market returns may not have been average. She might’ve caught a bear market and had really low returns for five years.
So, should Olivia be investing this way while dealing with student loan debt?
“Do you have an employer plan with a match? If the answer is yes, then definitely use your plan up to the match and use the rest of your money to pay down the loans,” advises Jill Schlesinger, CFP®, CBS News business analyst and author of The Dumb Things Smart People Do with Their Money. “If you want to get into the habit of saving for retirement, yeah, put 5 percent in, but don’t go crazy, because we do have to pay off your debt. And the debt’s not going away on its own. I’m someone who has lived through so many crashes and so many horrible events that I’m really risk averse. So, in my mind, I’d much prefer to take a sure thing of paying down a 6 or 5 percent note that’s really not going to do much for me. Yes, it depends, and yes, there are different folks that will be able to earn more, but for most of us, it’s just a balancing act.”
But What If Your Situation Is Nothing Like Olivia’s?
Olivia is a fortunate, fictional character. She has enough money month to month that her bills are paid, she’s got living expenses on lock, she has money going toward financia
l goals, and she can still put $200 toward investing. Uh, eye roll please. Who lives like that?
I get it. It’s rare to have a situation like Olivia’s. You may just be at the point of feeling in control from month to month and feel good about having a spare $25 a month to invest. That’s okay. For one thing, your situation is going to change. Debts will start to reduce. You’ll eventually start earning more. You will get to a point where you have discretionary income to put toward investing.
In the meantime, you should at least be investing in your employer-matched retirement account as a means of investing while you’re paying off student loans.
Consider Why You’re Investing While in Debt
You must never forget the importance of goal setting, time horizon, risk tolerance, and asset allocation. These factors are particularly critical when it comes to deciding if it makes sense to invest while paying off debt. When will you need this money? If you’re on a medium-term time horizon of under ten years, does it make sense to put risk on the money, or would that money be better served getting you to debt freedom? Can you emotionally handle seeing your investments drop during this period?
Have You Considered Refinancing?
Refinancing is the act of taking out a new loan to pay off an existing one. It sounds sketchy as hell when you put it that way, but it can be a valuable tool. Let’s say Toru is carrying $20,000 in student loan debt at a 6.5 percent rate on a ten-year term. He applies and gets approved for refinancing at a 4.5 percent rate on a ten-year term. Not only can he now pay less in monthly payments, but he will also save more than $2,000 in interest over the life of the loan.
Refinancing your student loan debt to get a lower interest rate enables you to attack the debt more efficiently and also free up funds for other financial goals. Unfortunately, it’s easier said than done. You may find that it’s harder for you to get approved than you expected or that the interest rate you’re offered isn’t as competitive as you’d hoped. Refinance companies don’t readily share underwriting criteria for approval, but the ideal candidates have strong credit scores (700+), have completed their degrees, have been employed for at least a year, have never missed a student loan payment, and it doesn’t hurt if they have a healthy salary.
Douglas Boneparth and his wife, Heather, refinanced their loans from Heather’s law school degree and Douglas’s MBA. “Heather and I refinanced more than $300,000 from the federal rates of 6.8 percent to 7.9 percent down to 2.95 percent. We went from a thirty-year repayment plan down to fifteen years for $200 less a month. It’s the Holy Grail of refinance situations. It allowed us to not only free up cash flow each month, but also cut the term in half and pay tens to hundreds of thousands of dollars less in interest over the life of the loan.”
The downsides of refinancing: You turn federal loans into private loans, which means you lose eligibility for any federal programs, such as debt forgiveness or income-driven repayment plans. Also, with private loans, deferment and forbearance, which allow you to temporarily stop making payments on your student loans due to hardship circumstances, aren’t as easy to come by compared to the options for federal student loans. Student loan refinance companies include: SoFi, earnest, Laurel Road, and CommonBond.
When Do the Experts Say It’s Okay To Be Investing While in Debt?
There is not one specific interest rate upon which the entire industry agrees, except that if it’s high—especially in double digits—you should focus on paying off your debt first.
“If you have a very low interest rate on that student loan debt and it’s less than 5 percent or less than 4 percent, you might consider investing into the market while you’re also paying that off,” says Julie Virta, senior financial advisor with Vanguard Personal Advisor Services. “We look at it from a financial situation. If you expect your portfolio to earn 6 to 8 percent, and your student loan debt is at 3, 4, or 5 percent, maybe, you’re better off investing your dollars.”
Virta does advise considering the climate in which you’re investing. After the Great Recession the stock market experienced a bull run from 2009 through 2018, but analysts and experts have been anticipating a market correction and less aggressive returns in the coming years. No one has a crystal ball, of course, but always do your research about recent returns before deciding to invest while paying off debt.
“We tend to say: anything above 7 percent, pay it off,” says Sallie Krawcheck, CEO of Ellevest. “For context, the stock market on average, since the 1920s, returns about 9.5 percent annually. Now, some years it’s been a lot better and some years it’s been a lot worse, but that’s the annual average. We believe a well-diversified investment portfolio should return about 6 percent annually. That gives you a guidepost.”
“People should have an emergency fund and no high-interest debt before they start investing,” says Alex Benke, vice president of Financial Advice and Planning for Betterment. “You could have mortgage debt and student loan debt, depending on the rate, before investing. Five percent is what we [at Betterment] use as cut-off on student loan debt.”3
That being said, Benke also advises to still take advantage of an employer-matched retirement plan, even if your student loan debt is above 5 percent. The 5 percent rule refers to general investing in taxable accounts.
In fact, all the experts I interviewed for this book agree that when you have the option to invest in an employer-matched retirement account, you should do it.
STEP TWO: AT LEAST INVEST IN RETIREMENT VEHICLES
“With this generation and the next generation that’s coming out of school with so much debt, if you wait to invest until you pay off the debt, you’re at a real disadvantage,” admits Jennifer Barrett, chief education officer for Acorns.
As discussed in chapter 4, sticking money into a 401(k) or 403(b) is investing. Well, it’s investing as long as the money isn’t just sitting in the account in cash. Even when you’re carrying student loan debt, it’s important to think long-term about retirement decades from now.
“It’s not either/or,” advises Colleen Jaconetti , CFP®, senior investment analyst for Vanguard Investment Strategy Group, who acknowledges that people love to come up with a million reasons not to save. “It’s the difference between what you are paying on the debt relative to what you could make in the market. And be realistic about what you could make in the market. Certainly, if it’s high credit card debt, like 25 percent, pay that off first. If we’re talking student loans at 2, 3, 4 percent relative to what you could make in the market, definitely consider investing at least up to the match. Get the match on your 401(k) before paying extra on the student loans.”
To give an example, let’s meet Erica:
Erica is paying off $30,000 in student loan debt at 4.66 percent with a monthly payment of $313 on a ten-year plan. Putting money into her employer-matched 401(k) is not a top priority right now. She’s earning $55,000 a year, and her company will match her contributions up to 4 percent. In real talk, that means if Erica puts $2,200 a year in her 401(k)—which is 4 percent of $55,000—then her employer will also put $2,200 a year in to match her contribution. That’s roughly $84.60 out of each of her biweekly paychecks, a sum that is also about half Erica’s monthly student loan payment. Erica would rather put that extra money toward paying off her debt quickly.
But here’s the issue: Erica’s leaving $2,200 a year in free money on the table. She can only get the employer match if she contributes to her 401(k) herself.
Erica is a Millennial, so the odds of her staying with this company for a decade may be slim, but let’s just say she does. For ten years, she picks up an additional $2,200 from her employer simply by contributing to her 401(k). That’s an extra $22,000 before market returns. And come on, obviously Erica will get promotions and raises, so it will definitely be even more than $22,000 over a ten-year period.
Now let’s go back to the student loan debt. In the decade it would take Erica to pa
y off the $30,000 at 4.66 percent with a monthly payment of $313, she would pay about $7,590 in interest. That means, in total, her student loans cost her $37,590.
If Erica put an extra $169.20 a month toward her student loans instead of her 401(k), she would pay off her loans in six years (about four years faster) and save about $3,200 in interest. That sounds great, except the math doesn’t actually add up.
In those six years, she could’ve put that $2,200 a year into her 401(k) and received an additional $2,200 from her employer, for a total of $4,400 a year.
What would Erica’s 401(k) look like if she been putting in $2,200 and getting matched for six years, with an average annual return of 7 percent? She’d have nearly $32,000 in her retirement savings. That’s almost the full amount of her student loan. If she lets that money continue to grow while she contributes that $4,400 a year to it, in four more years, she’ll have amassed about $61,000. That’s $30,800 more than her entire student loan debt. It’s a hell of a lot more than the $3,200 she saved in interest by paying off her student loan debt more quickly.
“What is it costing you to service these loans, and what opportunity costs are you missing out on by not investing?” asks Jaconetti.
Erica, do the right thing. Invest in your 401(k).
I’m Self-Employed, with No Employer Match— Should I Still Prioritize Retirement?
Not everyone has the luxury of a 401(k) option. I’m a self-employed Millennial, too, so I get the struggle of deciding between funding today’s financial goals versus putting money into an account that essentially locks away your money until you’re fifty-nine and a half. Not to mention that we don’t get the bonus of an employer match.