Guest post by Jacob, the creator of @DollarDiligence! A millennial blogger, freelancer, and teacher working to save you more money each month. Jacob proudly paid off $25k in student loan debt in 15 months.
Many students graduate with a degree and a mountain of debt. From personal experience, I can tell you that student loan debt can be psychologically oppressive, and it’s not unusually for folks to make many sacrifices as they work to pay off student loans as quickly as possible. We can’t really gainsay the emotional relief this provides, but we do want to point out that a little financial logic can help you make the best decision for your personal circumstances.
The Student Debt Landscape
U.S. student loan debt clocks in at more than $1.5 trillion, and 44 million Americans share this debt. More than 11 percent of the debt is delinquent (more than 90 days past due) or in default (at least one year in arrears). About 10 percent of a student debtors have private student loan debt, some with interest rates as high as 14%. The average monthly payment is $351 for borrowers between 20 and 30 years of age. If you have a decent income, you might find it possible to repay more than the required amount each month, and thus pay off your loan before it’s due.
A rainy-day fund makes sense, no matter how much debt you carry. Unexpected expenses have a distressing habit of popping up with little notice. If you apply all your disposable funds to student loan repayment, you might have to take on more debt to handle unplanned expenses. It’s simpler to sock away a few months’ income into a savings account and not worry about scrambling for emergency money.
The decision as to whether to pay down debt or invest might be less clear cut. However, in many cases, the power of compounding wins the argument, especially when you invest for the long term. Investing for retirement is a very good idea, and the sooner you get started, the more you can accumulate during your working years. Compounding gains power over long periods of time, as you earn money on your earnings as well as your initial investments.
Granted, the stock and bond markets can go up and down, so your returns are by no means assured. However, look at the average returns from 1967 to 2016. Stocks earned 11.45 percent a year, while bonds returned 7.08 percent annually. The take-away is clear: While markets fluctuate in the short term, investments have a long-term bias towards growth, and the sooner you open a retirement account, the longer you have to ride out short-term volatility.
It’s fair to assume that your average annual returns from long-term investing will be in the high single digits or low double digits. These returns can compound tax-free or tax-deferred by investing through a tax-advantaged retirement plan, such as a 401K or an IRA.
How to Invest
It’s clear that investing at an early age offers the best long-term results. But what should you invest in? Research indicates that costs are decisive. It’s true that diversification and asset allocation play large roles in your investment success (or failure), but no one can dispute that higher costs produce lower returns.
You can control asset allocation, achieve diversification and minimize costs by investing in non-managed index funds. For example, you can buy shares in an exchange-traded fund (ETF) that mirrors the S&P 500 index for a low commission and a management fee below 0.10 percent. It turns out that it’s very hard for active fund managers and stock brokers to outperform index funds over time, so why pay for them? You’ll find low-cost ETFs or mutual funds for a variety of assets, including equities, debt and alternative investments (gold, real estate, commodities, etc.).
The Bottom Line
In the end, you want to compare the returns from paying down your student loan debt and investing in a diversified portfolio of different asset classes. If your average student loan interest rate is, say 4 or 5 percent, that’s your annual return if you pay off you loan. That’s not bad, but you might be able to double that return in a retirement account. Add to that the tax advantages these accounts provide, and the case for investing seems like the winner.
If you’re still undecided, here’s an idea: Divide the money you would use for repayment or investing, and do both. You’ll still knock years off your debt repayment, plus you’ll begin earning, and compounding, returns. That’s a win-win scenario.