Education Debt – Is it a barrier to investing?

By Hightower Westchester on October 14, 2016

Many millennials graduate college with an unnerving amount of student debt.  The question is, once you graduate from college and land a job, do you begin saving for your future or pay off that student debt?  This is a question that is becoming more and more relevant, as the student debt numbers continue to soar.

There are many reports out there showing that the average student graduates with approximately $30,000 in student loan debt.  Yet it is the type of student loan that largely determines whether to pay these loans off as quickly as possible or pay just the minimum and invest.

The simplest answer is if you’re student loan debt has a higher interest rate than your investment, pay your student loans.  If your investment earns more interest than your student loans will cost in interest, invest.  A more real world example – interest costs on loans with interest rates above 5% will likely offset any possible investment gains, so it would make more sense to begin to make extra payments toward these loans to reduce total interest expense.  On the other hand, if the rate on the loan is less than 5%, it generally makes more sense to invest any extra dollars, rather than paying off your loans faster.  For example, the S&P 500 has averaged a roughly 5.5% annual, inflation adjusted return over the past 10 years, so the dollars you would have put toward extra loan payments would not have decreased the interest expense by as much as you would have gained in investment returns.  Below is an example of an individual who has the option of investing in a tax deferred retirement account or paying off their student loans.

While some federal student loans may have low, manageable interest rates, other loans do not.  That’s why it’s important to figure out what the interest rates on all of your loans look like.  Do you have multiple loans with varying rates? Or did you recently consolidate to a moderate-to-low rate?

The answer also depends on many other factors, from your individual feelings regarding debt, risk tolerance and financial goals to the amount of your debt and your interest rates.  For example, if you’re a recent college graduate, you might want to prioritize a few other things such as establishing an emergency fund.  We consider 6 months of total living expenses to be a good starting point.  Or maybe you want to pay down any credit card debt you may have, since the interest rate you’re paying on that debt is likely much higher than the interest rate on your student loans and is not tax-deductible.

The one big exception to this advice is investing for retirement.  The long-term effects of compounding can be huge, and the younger you are, the more years you get to benefit from compounding.  So before we even think about student loan payments, you should put some money away for your golden years.    And if you work at a company with 401(k) or 403(b) matching, you’ve got an even better reason to take advantage of the match and stash even more money away.

There are also tax deductions that play into this equation as well.  Although your student loans take longer to pay off with this strategy, interest from them may be tax-deductible, which is a big benefit come April 15.  There are many student loan payoff or invest calculators online that help determine your repayment strategy.  Understanding this equation helps clarify that your decision doesn’t have to be either-or.  If you decide to do a little of both, adding to your investments and paying more than the minimum on your student debt, it can be a hedge against a time where your budget may be a little tighter.

There are a lot of things to consider so it’s advantageous to receive strong and sound advice around such important financial decisions as there are many things to consider that may not readily come to mind.  For example, if a young adult plans on purchasing a home, their decisions around debt become paramount.  As with student loan refinancing, a mortgage lender will calculate your debt-to-income ratio to determine your ability to make monthly payments on the new mortgage.  It is important that you decrease your debt-to-income ratio.  When buying a house while carrying student loan debt, you need to be aware of the impact your loans have.  Having an advisor or a CPA to guide you in the right direction can make this, and many other complex decisions a lot easier for a young adult.  They can also help you put a financial plan in place that will incorporate your goals for debt repayment, investments, large purchases, savings, etc.  The older you get, the more complex your financial situation becomes, so it’s never too early to start planning.

So, what makes more sense for you in terms of paying off your debt or investing?  Ultimately, there’s no right or wrong answer, it’s the one that best fits your unique circumstances.  In the end, the decision on how quickly you want to pay off your student loan debt is a personal decision.  If you have other debt that includes a higher interest rate, it is better to focus on paying that down first.

Richard Flahive – Senior Wealth Management Analyst – HighTower Westchester
914.825.8639 – rflahive@hightoweradvisors.com