The “Should I pay off my student loans or save for ___?” question has become much more important as of late.  The average student loan debt for Class of 2019 graduates was $29,900.  

With the standard 10-year repayment term, this generally equates to a $300 – $400 monthly payment, which can make up a substantial portion of a new graduate’s monthly income.


Monthly student loan payments range between $300 and $440 for 2019 graduates


Recent graduates are having to weigh the burden of student loan payments against other financial goals, such as traveling, buying a house, saving for retirement, having a child, and ____ (fill in the blank with your top financial priority).

With the many different student loan repayment options available to some graduates, as well as the sudden influx of income from being gainfully employed, you have probably thought a time or two about where you should be directing your excess income.

While “mileage varies” for each individual, here are some things you might want to consider when deciding between paying off your student loans or contributing to other financial goals.

Should You Pay Off Your Student Loans Or…

1. Save For Emergencies?

The emergency fund.  Is there anything less exciting?

The general purpose of an emergency fund is to give you three to six months of buffer for critical expenses in case you lose your job.  Vanguard recommends that you estimate three to six months of costs for housing, food, insurance, utilities, transportation, personal expenses, and debt.

Traditional advice mandates that your emergency fund can be a specific separate account that you contribute to; however, many savers have trouble consistently saving in a dedicated emergency savings account.  It’s like paying for insurance when you are not “required” to (like renter’s insurance). 

If you are one of those troubled savers, a “piecemeal approach” may work better for you.

For example, if you lose your job, you can apply for forbearance on your student loans, dip into any savings or investment accounts that you are using for other major financial goals, scrape some from retirement, and/or use credit cards (and/or a loan from your parents??).  You can also include income from gig services like Airbnb, Uber, and/or Lyft in your “emergency fund.”


You can use loan forbearance, gig services, savings for other goals, etc. as an alternative “emergency fund”


When you add all of those sources up, it may make up a portion or all of the emergency savings you would need over a three to six month period.

While not setting aside six months of expenses in a cash account may lead to a little financial pain, if you can get through the emergency with other resources and get back on your feet quickly after, then a separate cash account may be overkill. 

If, however, a financial emergency would be highly likely to cripple you financially, and it would take a long time to get back on your feet or pay off any newly acquired credit card debt, then you are better off building up savings in a separate emergency fund rather than paying off student loans quicker.


Pay off student debt if you’ve built up savings and/or have other financial resources to mitigate an emergency


2. Invest In Retirement?

Retirement savings can come in many forms, such as Roth IRAs, traditional IRAs, 401(k)s, and many others.  In addition, the investments selected in retirement accounts can range from cash to high-risk, speculative stocks.

To decide between saving for retirement vs. paying down student loans, we just need to compare the “rates of return” between the two. 

Recently disbursed undergraduate federal student loans have an interest rate of 4.53%. Graduate loan interest rates range from 6.08% to 7.08%. In comparison, Investopedia states that the average annual return for the S&P 500, which is a stock index or “benchmark” composed of many major U.S. companies, is around 10%.

If your retirement account is invested in a fund that mirrors the S&P 500, then prioritizing retirement savings over college savings could result in a net positive annual return of around 3% to 5.5%. 

For example, if you only make the minimum payments on your student loans and divert the rest of your available income to retirement, you will be “negatively affected” by the 4.53% interest on the student loan debt but could benefit from the 10% annual returns on your stock investments, for a total potential net benefit of around 5.5% per year.


Investing in the stock market vs. paying off student loans could result in a +5.5% annual return


Some caveats on this analysis…

You are not guaranteed a positive return when investing in the stock market.  You may lose 20% one year, gain 30% the next year, come out flat the following year, and so on.  In general, you should expect to have a 10-year time horizon on the money you invest in the stock market if you are relying on the estimated 10% return number.

You may qualify for a tax deduction on student loan interest paid each year.  The tax deduction can lower your income by a maximum of $2,500 each year, which in turn can lower the amount of taxes you will owe (or increase the amount you get back) in those years. 

However, this effect is generally not large enough to erase the differential between investment returns and student loan interest rates over time.

For higher-rate loans, such as the 7.08% graduate loans, it may make sense to pay those down before saving for retirement.  When you pay down a student loan, you get a “guaranteed return” on that money because there is no “risk” that your payment will not lower your outstanding student debt. 

If you invest in the stock market, there is always a risk that your investments may not achieve the return you are looking for in the timeline you are considering.

However, keep in mind that when you pay down student loans, you don’t get to ask for that money back if you need it down the road.  When saving for retirement, you can usually access that money in the future, although sometimes there are early withdrawal penalties associated with doing so.


Save for retirement unless your student loans have high (generally 7% or higher) interest rates


If your retirement account is a 401(k) with matching contributions from your employer, there are very few scenarios where contributing enough to get your full match would not be the right move. 

If an employer matches your contributions dollar-for-dollar, that results in a guaranteed 100% return on your investment, before factoring in any investment growth.  It’s pretty tough to find a guaranteed 100% return anywhere else.


If your employer matches 401(k) contributions, max out the match before paying down student loans


3. Save for a House?

This is a tricky one because buying a house is not always purely a financial goal.  For some people, homeownership provides a non-monetary benefit – a piece of “the American Dream.”

Let’s compare returns first.

The Federal Reserve of St. Louis’ historical data on median sales prices of houses sold in the United States indicates that the annual return on houses over the last 10 – 30 years has been about 3.75%.  Over the last 55 years, the annual return has been about 5.5%.


Annual returns on U.S. housing has averaged around 3.75% over the last 10 – 30 years


Both values are reasonably comparable to student loan interest rates.  However, we have not factored in that you actually have to live somewhere, and if you do not own a home, you likely have to pay rent.  When you factor that in, the annual return on homeownership can range between 5% and 6%.

The real magic happens when you take out a mortgage for a home.  This can boost your annual return to greater than 10%, depending on how much your down payment is (a concept known as “leverage“).  This results in a much higher return than paying down student loans.


Owning a home can have a greater-than-10% annual return when factoring in “leverage” from your mortgage


So, in general, you should save for a home rather than pay down student debt.  However, your student debt can actually prevent you from buying a house if it takes up too much of your monthly income. 

Your debt-to-income ratio (DTI), which is a ratio of your monthly debt payments (including your anticipated mortgage, insurance, property taxes, and other costs associated with purchasing a home) divided by your monthly income, generally must stay at or below 0.45 for you to qualify for a conventional mortgage.

So, if you bring in $4,000 a month of income, and your monthly student loan payment is $400, then assuming you have no other debts, you will have $1,400 available for housing expenses (any additional would put you over a DTI of 0.45). 

If that is not enough to buy the house you want in the area you want to live in, it may make sense to pay off some of your lowest-balance student loans so you can quickly increase your purchasing power.


Save for a house unless your student loan payments prevent you from qualifying for the house you want


4. Pay Off Credit Cards?

In almost every scenario that involves credit cards, paying them off is the right move.  Pay them off and don’t rack up credit card debt ever again. 

Use your credit cards for the rewards points, but if that entices you to spend more than you can pay for, cut them up on move on to greener pastures.

The average credit card rates reported by ValuePenguin range from 15.9% to 20.9% – several multiples above the current student loan interest rates.  If you have credit card debt that is accruing interest, stop reading this article, and go make a payment right now! 

It may even make sense to get a forbearance on your student loans if your credit card debt is going to take a long time to pay off.  Before doing so, check with your student loan service provider to make sure that you will not forego any eligibility for student loan forgiveness if going that route.


Pay off your credit cards – even consider getting a forbearance on your student loans


5. Invest in the Stock Market?

The majority of the previous “paying off student loans vs. saving for retirement” discussion applies to general stock market investing as well.  Investing in a fund that mirrors the S&P 500 is generally assumed to return 10% annually over a ~10-year period. 

If you invest in the stock market in a general, non-retirement brokerage account, you may have some additional taxes on capital gains that you wouldn’t have in a retirement account, which will lower your “effective return” a bit. 

However, unless you have high-interest student loans, typically around 7% or higher, it is generally better to invest in the stock market than pay down student loans. 

Not only can investing in stocks earn you a higher return, having access to your savings should you need it for an emergency or a down payment on a house adds an extra benefit.  When you pay down student loans, you cannot ask for that money back later.


Invest in a stock fund that mirrors the S&P 500 unless your student loans have 7% or higher interest rates


6. Save for My Child’s College?

You can insert most of the discussion about saving for retirement in here as well.  If your child’s college fund is invested in a fund that mirrors the S&P 500, you will generally earn a higher return than paying down your student debt.

However, saving for your child’s college is different than retirement in that you have a finite amount of years to accomplish this goal – generally up to 18.  So, if saving for your child’s college is a top priority of yours, delaying college savings to pay down your student debt may significantly hinder your ability to achieve this goal.

Saving for your child’s college is also different than retirement because it impacts the net worth of somebody other than yourself.  Although you may earn a higher return in the college fund account than you would by paying down student loans, you are giving those stock returns to somebody else (i.e., your future grad) while keeping the negative returns of your student loan debt for yourself.

If you’re debating paying down your student loans vs. starting your child’s college fund, the good news is that you can do both!   Using the college fund as a gift sourcing tool can help you get gifts from friends and family so that you are maximizing your limited years of investment returns in the college fund while still paying down your student debt.


Use your child’s college fund as a gift sourcing tool while paying down student debt


Love,

SavvyFi