For many student loan borrowers, it may seem daunting both to pay off your student loans and save for retirement.
Everyone wants to do both, but it may be financially challenging or hard to find the right balance.
So, let’s explore your options and determine which works best for you.
The student loan vs retirement reality
According to Make Lemonade’s Student Loan Debt Statistics For 2017 Report, there are 44.2 million borrowers in the U.S. who hold more than $1.3 trillion of student loan debt. Of this total, more than two million student loan borrowers have student loan debt greater than $100,000, with 415,000 of that total holding student loan debt greater than $200,000.
For many student loan borrowers, saving for retirement is a distant goal often displaced by an immediate goal to pay off student loans.
That’s a natural thought process. Psychologically, it can feel better to pay off debt first.
Think of it this way, though:
Your student loans represent your past. They were essential to help you obtain your degree and advance in your career, but now that you have graduated, your education is behind you. You know that your goal is to reduce your student loan debt each month, but for each day they are outstanding, you incur more student loan interest. From your lender’s perspective, you are an investment in your lender’s future.
What about your investment return?
Saving for retirement represents your future. Whether you’re in Generation X, Y, Z or a millennial, it is never too early to start saving for retirement. Saving for retirement should not be viewed as another monthly expense. Rather, saving for retirement is an investment in your future. For every dollar invested in a retirement plan between now and your retirement, that investment will continue to grow through the power of compounding.
For example, if you contribute $100 per month to a retirement plan starting at age 25 until you retire at age 65 and your investments earn eight percent per year, your retirement account balance will grow to $354,075.
Therefore, a dollar saved is several dollars earned.
Should you pay off your student loans or save for retirement?
The best answer: You should do both. If you have the financial resources, pay off your student loans and investment for retirement. (We will discuss how to balance these two in a moment).
After living expenses, taxes and other loan payments, however, balancing both student loan repayment and retirement investment is easier said than done for many student loan borrowers.
Here are three main options for you to consider:
- Pay off your student loans and save for retirement later
- Save for retirement now and pay only the minimum student loan balance each month
- Pay off your student loans and save for retirement simultaneously
Option 1: Pay off your student loans and save for retirement later
This may feel like the best option because this option enables you to be debt-free first.
However, this is a common mistake and the least desirable option. When you borrowed your student loans, you may have hoped to pay off your student loans within several years after graduation. The reality is that it may take longer than you expect to pay off your student loans. The longer you wait to save for retirement, the less money you will have by the time you retire.
There is an exception to this rule.
If you have private student loan debt at an interest rate higher than your anticipated investment return of your retirement portfolio, then arguably you could focus on repaying your higher interest student loan debt first. Since your student loan interest rate is higher than your investment return, you would save more money in interest costs than you could generate in investment returns.
Like any investment decision, there are other considerations such as taxes and student loan interest deductions or credits, among other considerations. However, tax-deferred retirement accounts are one of the best ways to grow your retirement portfolio.
If you have multiple student loans with varying interest rates, then focus on repaying only the student loans with interest rates higher than your anticipated stock market return. Then, if financial resources are limited, start saving for retirement as soon as possible (but do not wait too long).
Option 2: Save for retirement now and pay only the minimum student loan balance each month
This option is the inverse of Option 1. If you invest your retirement funds in the stock market, for example, do you anticipate that you will earn a higher investment return than your highest student loan interest rate? If so, then you will generate a higher investment return — and therefore more money — than you would by paying down your student loan debt at a lower interest rate.
Option 3: Pay off your student loans and save for retirement simultaneously
This is your best option, and here is how to balance between paying off your student loans and saving for retirement.
With this option, you can take the dual path toward repayment and investment. You are reducing debt and saving for your future — and, most importantly, starting early.
Remember, if you meet the requirements and have a strong credit profile (or a co-signer with a strong credit profile), you can refinance student loans to lower your interest rate.1 You can use the savings from student loan refinancing to invest more in your retirement account.
For example, if you have $100,000 in student loan debt and refinance your student loans from an eight percent interest rate to a four percent interest rate, you cut your interest costs from $8,000 to $4,000 per year. You can apply the $4,000 that you effectively are saving toward your retirement account.
You also have the option of student loan repayment plans and student loan forgiveness, including Public Service Loan Forgiveness and Teacher Student Loan Forgiveness.
How much money should you put toward paying off student loans vs. saving for retirement?
Don’t forget your employer match
If your employer offers a 401(k) match, consider this free money. With an employer match, your employer typically matches dollar-for-dollar your 401(k) contribution up to a certain dollar limit threshold.
For example, if your employer matches up to five percent of your salary, and you earn $50,000 per year, that means your employer will match your first $2,500 in 401(k) contributions. Therefore, if you contribute $2,500 to your 401(k), then your employer will contribute $2,500 — and suddenly you have $5,000.
At a minimum, you should contribute enough to receive your employer match.
Credit card debt
If you have student loan debt and credit card debt, the interest rate on your credit may be substantially higher. In this case, you will want to pay off your credit card debt first (given the higher interest rate) or consider a personal loan, which can potentially cut your interest rate in half.
Always pay at least the minimum student loan payment. Don’t skip any student loan payments because the penalties can be severe. Start saving for retirement as early as financially possible by contributing to your 401(k). Benefit from the power of compounding. Take advantage of your company match. Evaluate the interest rates on your student loans and compare them to your target investment returns.
Student loan hack: Contribute to your 401(k) to help qualify for the student loan interest deduction
With the student loan interest deduction, you can deduct up to $2,500 each year of student loan interest that you paid on a qualified student loan, so long as you are enrolled at least half-time and are working toward a degree.
To qualify for this tax deduction, you must have a modified adjusted gross income of $80,000 or less ($160,000, if married and filing jointly).
If your income slightly exceeds the income cap, contribute enough funds to a 401(k) to lower your modified adjusted gross income below the income cap. This way, you can save for retirement and qualify for the student loan interest deduction.