I had an interesting question come my way from a student the other day and I thought I’d expand on my answer that I gave to the student. The question was whether he should pay off his student loans and then start investing, or if he should start investing first and pay off the student loans gradually.
If we really look at it, paying down any type of debt is very similar to making an investment in a guaranteed account paying interest on the equivalent of the interest rate on the debt. This student’s interest rate on his debt was approximately 7%. Paying this off would not be unwise and would be a great way to earn 7% risk free – only this method keeps the 7% out of the lender’s pocket and puts it into the borrower’s.
However, if we completely ignore investing and saving for retirement we can miss out on some of the crucial, early years of investing where a young investor can take advantage of time, and compounding. Even a small amount set aside on a regular basis can reap huge rewards and returns over time through the value of compounding.
So here was my answer to the student. Depending on his risk tolerance, if he thought he could earn a return higher than 7% (subject to much more risk) than he could consider investing now and simply paying down the debt through the regular monthly repayments. I advised that deferring the repaying was not recommended.
If he thought he was a more conservative investor then he could consider paying a much larger amount monthly to reduce the debt even more, then, when the debt is paid off, use the free cash flow to enhance retirement savings.
Additionally, I told the student if he was participating in a 401(k) with a match, to definitely save into the 401(k) at least up to the employer match. This is free money from the employer and everyone should take advantage of this. Furthermore, the student should be aware that his student loan interest paid is deductible up to $2,500 every year as an adjustment to income (above the line deduction).
While I had no blanket answer for this student, it hopefully gave him an idea as to how he should think about his retirement savings and debt. The good news is that he was at least thinking about these things, which feels good. Sometime you wonder if you’re making a difference.