Should you pay off student loans or invest?

Considering that most people expect to be paying their student loans for most of their lives, some may wonder if it is wise to invest before the loans are fully paid.

Whether you should use your discretionary income to pay down student loans or invest depends on factors like your interest rate and financial goals. If you desire to become debt-free quickly, putting your extra money toward removing student debt is ideal. However, investing could be a better option if your expected rate of return is higher than your student loan’s interest rate or if you want to work on your financial security. You could also choose to do both.

When to pay off student loans

Paying off student loans before investing can take some time, but for many borrowers, it can relieve a lot of stress and free up more cash for other goals, including investing. It can also make your life feel a little less complicated.

You should consider paying off your student loans if you have high interest rates, you have an unpredictable cash flow or you’re looking to remove debt from your finances.

Pros:

• You’ll save money in interest. Paying off your student loans early can help you save hundreds of dollars in interest.
• You’ll become debt-free sooner. The sooner you become debt-free, the faster you can put more money toward other financial goals like retirement.
• Improve debt-to-income ratio (DTI). Making extra payments toward your loans can lower your DTI ratio — which compares your monthly debt against your monthly gross income. As a result, it can make it easier to qualify for a mortgage.

Cons:

• Lengthy repayment period. Paying off your student loans can take several years, even with extra payments.
• May not be beneficial. It’s unnecessary if you’re working toward loan forgiveness or repayment assistance.
• Miss out on building wealth. Not investing any money can cause you to miss out on potentially greater returns than your interest rate.

Best for:

• People whose top priority is to be debt-free.
• Borrowers with high-interest student loans (8 percent or higher).
• Borrowers who have private student loans with a variable interest rate.
• People hoping to purchase a home but can’t because of a high DTI.

When to invest

Investing sooner rather than later can help set you up for a successful retirement as you take advantage of the power of compound interest. While investing never offers a guaranteed return, if your research shows that the rate of return for your investments will likely be higher than the interest rate for your loans, it could be a good idea to start investing.

Pros:

• Possible better rate of return. You can often get a better rate of return than most student loan interest rates.
• Retire sooner. Investing sooner will help you avoid working longer in your older years.
• Flexible withdrawal rules. With certain investment accounts, you can withdraw if you need the money in the future.

Cons:

• You may still struggle with your monthly payments. Depending on your income, investing while paying off student loans may be challenging.
• Investing won’t help improve your DTI. Unlike paying down debt, investing doesn’t lower your DTI ratio.
• Investment risks. All investments come with the risk of losing money — returns aren’t guaranteed.

Best for:

• Borrowers with a low interest rate on their student loans.
• Borrowers who are enrolled in a student loan forgiveness plan.
• People who already have investing knowledge.

Pay off student loans or invest: Factors to consider

Cecil Staton, president and wealth advisor at Arch Financial Planning, says that when it comes to choosing between paying off your loans and investing, it’s more a question of “opportunity cost.”

“Do you expect a higher rate of return than the interest rate charged to your student loans?” Staton says. “If so, it could make sense to invest. If not, aggressive repayment strategies may be in your best interest, and you may delay investing. Ultimately, a balance between the two usually makes sense.”

Here’s what to think about when deciding between paying off your student loans and investing.

Personal priorities

Start by thinking about your overall financial picture. You need to consider your other debts, savings goals and personal priorities. Here are some other goals you might decide to prioritize:

• Save for emergencies: Before paying off student loans or investing, save at least one month’s expenses. Over time, try to build up to six months’ worth of expenses.
• Save for retirement: If your employer offers a 401(k) match, take advantage of it. Explore other opportunities outside of a 401(k) to start contributing to retirement accounts and saving for your retirement.
• Pay off high-interest debt: Credit card balances, personal loans and other types of debt might have high interest rates. Paying these off first can give you a higher return than investments or student loan debt.
• Tackle big life goals: If you want to have kids or save for a house down payment, you might decide to make minimum payments on your debt and hold off on investing for now. This gives you space in your budget to save for those bigger financial milestones.

A final personal priority to consider is whether becoming debt-free is your top goal. If so, you may want to hold off on investing and put all excess funds toward paying off your student loans early.

Interest rates

Depending on when you borrowed the money and whether you have federal or private student loans, interest rates can range anywhere from 1 percent to 13 percent. Paying down your debt is like a guaranteed return on the money, so if your student loan interest rate is 5 percent, you get a 5 percent return.

Compare this rate of return to your expected investing return. Stocks can generally offer a long-term rate of return of over 9 percent a year. However, returns can be volatile if you’re investing for the short term.

If your student loan interest rate is lower than what you can realistically expect to earn investing, then it could make sense to prioritize investing over paying down student loans early.

Tax deductions

When you’re paying off student loans, you might be able to deduct interest payments you make on that debt. Eligible borrowers can lower their taxable income by up to $2,500, which helps offset the cost of student loans over time.

At the same time, you can also deduct contributions made to a 401(k) or traditional individual retirement account. Think about which tax break is more important to you.

Forgiveness programs

If you have federal student loans, you might be able to get student loan forgiveness, which eventually cancels all or some of your student loan debt. If you plan to take advantage of student loan forgiveness, then it doesn’t make sense to put extra payments toward the debt. You could instead put the extra money toward investing and grow your money over time.

But look closely at the loan forgiveness details to ensure you meet the qualifications. This may affect your decision to enroll in one of these programs or to start investing now.

The bottom line

Deciding whether to pay off student loans or invest depends on your financial priorities and which option gives you a better return. If the rate of return in investing is higher than your student loan interest, then making minimum payments on your student loans and putting any extra cash toward investing may be a good choice. Conversely, if your student loan interest is higher than any possible return on investment, then focusing on getting out of debt faster may be the better path.

It’s important to note that, depending on your financial situation, you may not have to choose to invest over repaying student loans faster or vice versa. If you need help deciding what to do, contact an investment professional.

Frequently asked questions

• What are the best kind of investments to make to help pay student loans?

  The answer to this question depends on your financial situation and risk tolerance. That said, investing time in mastering an in-demand skill may help you get a promotion at your existing job or a job in a higher-paying field. Then, you could put the extra cash toward paying down your student debt. If you prefer more specific investment advice, consider contacting a Certified Financial Planner (CFP).
  

• What kind of investments should you avoid if you want to repay student loans quickly?

  While the answer depends on your unique situation, it’s generally a good idea to avoid high-risk assets, like cryptocurrency. The Security and Exchance Commission (SEC) recommends only investing what you can afford to lose in speculative investment vehicles.
  

• Should you contribute to retirement investments if you have student loans?

  Whether you should make contributions to your retirement account while repaying student loans depends on your financial circumstances. If you can afford to invest and pay down student debt at the same time, doing so may be a smart idea. However, if contributing to your retirement account puts you at risk of defaulting on your loan, consider prioritizing repaying your loans.