When recent college graduates work on creating a first budget, one issue that may come up is choosing between paying off principle on student loans or putting that money into investment or savings. The problem is that there is no simple answer, and even after all of the known variables are considered, one still has to guess or approximate the expected return on their investments and their personal willingness to take financial risks.
First of all, its a good thing to have some cash in the bank for emergency situations like injury or losing a job. A common rule of thumb is to have enough money to make it through about two months worth of fixed costs (rent/mortgage, food, utilities, and monthly credit payments).
- The problem with non-cash savings is that they can be difficult to convert into money instantly – bonds have to mature, real estate can sit on the market unsold, and stocks could be at a temporary low and selling at a forced time could cause a substantial loss
- The benefit is that these are the true vehicles to building wealth since cash is a constantly depreciating asset. Every day it seems, the dollar loses just a little bit of value and prices creep up.
Once you have some cash saved up to cover emergency and unexpected situations, its time to consider the non-liquid investments listed above versus student loan balances and interest.
- If the student loan is subsidized, chances are that your best bet is to just make the monthly minimum payments and forget about it. Most investments, even safe ones like government bonds, can get a better interest rate than what you’re paying to the student loan. It might just be 1 or 2% difference, but over the life of the payments you could earn thousands more from investing than you saved by avoiding the almost non-existent interest fees.
- If the student loan is private, the interest rate of the loan and your willingness to take investment risks determine your best outcome.
- Private loans to low income students or students in a family with a low credit rating can be at 10% or higher. If this is the case, you would almost certainly want to pay that principle off before investing. It is not impossible to get a 10% return in our modern bubble-oriented economy, but it is extremely risky. Unless the loan has pre-payment penalties, its a much safer decision to pay the debt as soon as possible. Even if it does, it may be worth it to pay the penalty to avoid the even higher interest bill.
- Private loans to students with high family incomes and/or good credit ratings are the ultimate gray area. The 5-7% interest rates are right in line with returns you could expect from fairly safe investments like certificates of deposit or moderate-risk mutual funds so you’ll have to base the decision on things like tax credits, and whether or not your employer matches any of your contributions to a 401k or similar investment plan.
Compounding interest is a powerful financial force, and based on your own personal situation it may be better to approach the debt side or the investment side as a top priority. All of these variables have to be considered, and even then there are risks that an investment in a particular company, fund, or any asset could lose its value due to some unforeseen change in the economy. Then again, if the dollar devalues too much, there is a risk that paying off your college debt could also backfire, financially.