The following is a guest post by Jacob from Dollar Diligence, you can follow him on Twitter here: @DollarDiligence
Should You Pay Off Student Debt or Invest in the Stock Market?
Things are going well with your job. You got your first promotion and big raise and now have some excess cash flow. In deciding how to use it, you look first to your student loan because you’ve been told that all non-mortgage debt is bad and you should do everything you can do to become debt-free. But, you also have the opportunity to increase your contributions to your 401(k) plan, which you know is important to help you achieve your goal of financial independence by the time you’re 55. So, which is it going to be?
The answer is not so clear cut. Everyone’s circumstances are unique and there are a number of factors that need to be considered, including the rate of interest on your loan, the returns on investment, your tax situation, your attitude about debt and risk and your ability to devise a plan and stick with it. Once these factors are addressed, you will have your answer.
Considerations for Paying Down Student Loan Debt
The decision to pay down debt rather than invest usually comes down to two factors – your attitude about debt and the cost of borrowing.
Attitude about Debt
If you have a real aversion to debt, paying it down quickly is going to be your first consideration. For some people, there is no better feeling than being debt free. It frees up cash flow and it allows you to pursue other financial goals. In order to achieve financial independence, you need to first gain your financial freedom by eliminating debt.
Cost of Borrowing
If you’re looking at high cost debt, like credit card debt, and your debt-to-income ratio is more than 40%, your first consideration should be to pay it off quickly. Some non federal student debt can have interest rates as high as 11%. If you’re paying interest in the double digits, there is no better use of your excess cash flow than to eliminate it as soon as possible. If your interest costs are choking off your ability to meet your basic living needs, you need to eliminate them. The sooner you can pay off debt, the sooner you can increase your savings and pursue your lifestyle goals.
Considerations for Investing
The most important advice for people who truly want to achieve financial independence is to invest early and often. Time is your most valuable asset, but it is a wasting asset. You also don’t want to miss out on free money when it is offered.
The Cost of Waiting
Time is what gives compounding interest its real magic. The more of it you have, the faster you can accumulate capital at less cost. Consider the example of two young adults who start their careers at age 25. Ryan starts investing $500 a month right away and stops at age 45. Richard puts off investing until age 45 and then starts to invest $500 a year for the next 20 years. If they both earned a 7% return on their investments, Ryan would have a total of $980,000 at age 65 while Ryan would have $253,000, yet they both invested the same amount of money. To catch up to Ryan, Richard would have to invest a little over $1,900 a month.
For Richard, the cost of waiting is the additional $336,000 he had to invest just to match Ryan.
Would you ever turn down free money? If you have access to a 401(k) plan, that is what you do when you don’t contribute enough to qualify for the full employer matching contribution. The other “free” money you get is the immediate tax reduction for your contribution. Receiving the employer match and the tax deduction is like receiving an immediate, guaranteed return on your money. Like time wasted, you will never get back the opportunity for that free money again.
As you can see, there is no absolute answer to whether you should pay down student loan debt or invest with your excess cash flow. No one likes the idea of paying interest any longer than they have to; but, the loss of time, tax breaks and free money can be equally harmful. For many people who are disciplined enough to stick with a plan, a blended approach might be the best alternative.