Finally reaching the point where you have positive cash flow to be able to choose to pay off your debt or invest is never a bad thing.
But it often creates some tough decisions for people.
When you’re dealing with credit card debt with APR’s above 10%, it usually is an easy answer: pay off the debt. You’re rarely going to consistently be able to make over a 10% on your investments.
When you’re dealing with a very low APR, for example, student loan debt of 2-3%, the answer is also pretty simple. Invest. It’s fairly simple to earn more than 2-3% via conservative investments in the market.
But what about when you’re right around that 5-7% mark? That’s when it gets tricky.
Reader, Lisa B., write in:
“I have about $15,000 worth of student loan debt at 6.25% interest rate. I am 27 years old and getting married this year. My partner is 29 years old. We do not have any retirement savings, but we also do not have any other debt besides my student loans. We will have about $1500 a month in disposable cash starting in the fall. Is it better to put the money towards my student loans or towards a retirement plan?”
It’s a tough question that many of us have or will come across.
On one hand, being 27 and 29 and not having any retirement savings is a bit of troubling red flag. Sure, Lisa and her partner have time to catch up, but if they don’t start a retirement savings discipline now, when will they?
On the other hand, 6.25% is a rather enticing guaranteed investment return in today’s volatile market.
I thought I’d pass it along to the readers to comment to get a variety of opinion.
- Focus on paying off the student debt first, before saving for retirement?
- Focus on retirement and pay off the minimum monthly payments on the student debt?
- Do both at the same time?
What’s your take?
with 1500 per month to apply either way (i can assume that this is outside of other commitments like a mortgage and budget allocations like groceries), it shouldnt be hard to open one retirement account and max out your yearly contributions in about 3 months if you wished. if i were in this situation, i would allocate 2/3 of this money towards student loan debt, and the rest towards a retirement IRA. then, i would be saving for retirement (at least in a small way) and paying a rather large amount towards the student loans. then, once the loans are depleted, and THE VERY MONTH that they are depleted, i would open an IRA for my spouse and begin contributions there as well, and a third account if possible (401k). that way, it would not give me time to get accustomed to having the extra money floating around waiting to be spent. i would be saving the maximum amount of my extra money towards retirement. at 15000 per year (max contrib for 3 accounts) that comes to a little under 600k by retirement age, not including any interest. plenty to get by, even without social security.
I’m confused by how you are getting that 15,000 is the max between the 2 IRAs and the 401(k). the maximum yearly contribution on a 401(k) alone is more than 15k.
401k limit is currently 16,500 and IRA limit is 5,000 for people under 50 or whatever the catch up age is. Those limits are mutually exclusive.
Those facts are all true, but I’m not sure how they relate to my comment?
I’d put 20% of her income towards retirement, then if she has any extra put it towards the student loans. She likely can deduct her student loans on her taxes and with having $1500 extra per month I assume she is in the 25% tax bracket. This would bring her loan percentage down to 4.70%, much more palatable.
There is a limit on how much student loan interest is deductible, and it is further capped by income. You can only deduct student loan interest on income up to $70k
The difficulty in giving a straight answer basically is the answer…both options are basically equally good.
First, the all important emergency fund must always come first. That wasn’t mentioned, but I that doesn’t exist, that’s the priority.
Second, I would suggest building up the retirement fund, automatically deducting into a 401k, if only to get into the habit of doing so. It doesn’t even need to be the main focus of all disposable income, but it needs to exist and become an integral part of their finances. I’d start with 10% of salary.
Until those two things are started up and growing through interest and automatic deductions, pay only the minimum on student loans.
Once a solid emergency fund exists, and 10% of salary is diverted, then and only then focus on the loan. After the tax deduction, the total amount of money made investing vs. paying off debt isn’t going to be significant in the long run. Building good habits, OTOH, pays dividends for a lifetime.
I’d suggest a 3 month emergency fund, first. Assuming this takes approx 3 months.
Then, set up automatic withdrawals to be on track to max out both Roth IRAs for the year (~1100/month) and put the remaining ~400/month towards interest.
That way they’ve built up a pretty aggressive habit of retirement savings, while still knocking down the loans.
I am not sure that you can claim 401K tax benefits and deduct student loan interest both in the same year. She should look into this so that the tax benefits are not nullified by a technicality. I am no tax professional but I remember something about this when I made this decision myself a few years ago.
You most certainly can as long as:
Your filing status in not Married Filing Separately.
No one else can claim you as an exemption on his or her tax return.
You are legally obligated to pay the interest on the student loan.
You actually paid the interest. Accumulation of interest on your balance by itself is not deductible.
You are probably thinking of the saver’s credit. You are right that the same person cannot claim saver’s credit and be a full time student. This does not apply to paying back the loan, and so wouldn’t apply to this case.
If they can pay $1,500/month and the student loans are $15,000, it should only take 10 months to pay off the student loans. Honestly, I’d plow through that first and then, like someone above suggested, arrange to immediately have that $1500/month put into retirement accounts.
However, if the option to put money into a 401(k) where there is an employee match, they may want to use enough money to get the maximum match, and then continue to use the rest to pay off the loans.
Please post back on what they decide to do!
It would be good to know if their employer offers matching funds for a 401k…if so, that may sway the equation.
I agree with Dani, that they should just pay off the loans. At $1500/month, they can get through that in 10-11 months tops, plus even sooner if they had extra. That way it is guaranteed, then snowball all the rest of that money into various retirement vehicles/emergency fund.
I struggle with what to do with my “extra” cash myself (student loans vs. retirement vs. investments vs. saving for a house vs. saving for a replacement vehicle…the list continues!)…but here is my take:
1. Establish an emergency fund.
2. Contribute to any employer matched 401k/403b. Employer matching is like getting an instant raise, especially if you are vested immediately!
However, if you don’t have matching available, then I’d suggest starting with an IRA. Roth IRAs are my favorite because of the long term tax benefits, but regular IRAs offer the immediate tax break.
3. Determine how much of your remaining funds you can afford to put toward your loans, presuming that you can afford to pay more than the minimum. I use this website to help me determine which student loans to attack first: http://www.whatsthecost.com/snowball.aspx
Need more info. Do either have a company match on a retirement plan (e.g. 401(k))? If so, at least contribute enough for the match.
Next, is the loan fixed or variable? Rates should be low for at least the next couple years, so I wouldn’t worry if it is variable. In fact, I would be more likely to save in that scenario.
Last, what do they have in terms of liquid funds? I would hate to see them payoff the loan only to have to run up CC debt in case of an emergency. Build a cash reserve before paying down a student loan at 6.75%
Good problem to have… I am facing an easier challenge: pay off a 4% mortgage (still amazed by that rate!), or invest. Clearly, I am investing. $55k mortgage. $44k retirement savings. $25k emergency fund. 40 years to retirement. $35k/year in expenses. $60k a year in gross income. Currently saving 20% of gross income for retirement. Very happy with our situation.
Correction: 6.25%, not 6.75% above :-)
1) Does your employer have 401k matching? If yes, contribute up to that matching limit. That is free money you’re giving away.
2) Do you think you can invest and beat a 6.25% return? If yes, then go invest (whether 401k or Roth is debatable). If no, then pay down your debt.
I think in this market/economy that getting a >6% return could be tough in the short term. Even after making your minimum 401k contribution it should only take ~12 months to pay off your debt. Now if an amazing investing opportunity arises (i.e. 2009 market crash) then switch to investing.
Also, I’m assuming you have an emergency fund. If not that should be your immediate priority after your minimum 401k match.
It’s definitely a loaded question…i would want to know what their salaries are like individually, and what each of their employers offers in the form of 401k matching. First and foremost, take the 401k match from either or both employers if they offer one. Next, consider if they make too much to claim the student loan interest deduction. Then determine if they are on the border of two tax brackets, and can potentially be lowered into another with increased tax deferred retirement savings… we know way too little to give Lisa an adequate answer.
I say focus on eliminating the student loan debt first, and then focus on retirement. If you do it the other way around, you’ll spend your retirement money paying off your debt, which isn’t going to be fun.
I’m gonna recommend doing both at the same time, which is what I’m doing. You may not see either number change by leaps and bounds, but paying off your debt and contributing to a retirement account are both great ways to better your future. I’m with Justin, above, that if your employer offers 401(k) matching, Lisa needs to take advantage of that. If their respective employers don’t offer 401(k) or they prefer another sort of retirement account, what I’d suggest is splitting the available income 60/40 or 70/30 and applying the greater amount to the debt while saving the smaller amount. Just have patience and the benefits will add up quickly.
Hi everyone! I’m Lisa B. Thanks for all the food for thought. I just wanted to also mention that my employer does not provide a 401(k) option. I live in Cambodia and work as a teacher and my fiance is an NGO consultant. One of the reasons we don’t have retirement savings yet is because we paid for our master’s degrees by working as we studied. Please keep the comments coming. I really appreciate it! Thank you!
I just re-read through the comments and wanted to add a few more things.
1. Our emergency fund was just depleted due to a break in between jobs, buying expensive plane tickets back to the States and having one month off in August (to return to the States to get married). We had about $30,000 in savings about 18 months ago but paid cash for 2 master’s degrees and volunteered for six months. All this has left us without much savings, but we are dedicated savers and are very good at sticking to a budget.
2. I make $1700 a month and my partner is currently making $1350 a month. This may not seem like a lot, but we live in Cambodia and get by on about $1500 a month for all of our living expenses. Unfortunately, this means we also do not get health insurance or 401(k) options.
Thanks again for all of your comments and thoughts. I am really enjoying it!
With that information in mind, I would save an emergency fund first ($4500 to $9000). Should only take about 3 to 6 months based on your current savings rate of $1550 a month.
Next, I would pay down the student loans (how much are you required to pay at a minimum each month?). Then, roll the money that was going into paying the student loans into retirement savings.
Seems a lot more complicated than I first thought… The tax implications are what really drive the answers usually, but in this case, not sure how the taxes work being an “expat” or “volunteer” in Cambodia?
The real question here is, be in a better position now, or in the future. Paying off debt now put you in a better position immediately. While retirement savings are 40 years off.
Given the turbulent markets(commodity, stock, and job),the fact that QE3 is ending, and Bernanke has admitted he doesn’t know why the economy isn’t recovering, paying off debt would be my preference. Especially since it has a guaranteed return of over 6% immediately.
Assuming you have an emergency fund of 3-6 months(average unemployed worker is out for 3 months right now according to BLS), my recommendation would be, pay off the debt first. Then invest about $1,000 a month in long-term retirement plan(bonds, stocks, gold whatever), and take the additional $500 a month and put it aside for your next vehicle purchase.
This is because vehicles are one of the worst things to finance and having $18,000 in 3 years to put towards a new vehicle will save thousands compared to financing the vehicle.
All that said, focus on Net Worth and you will be much better off.
Almost forgot, if you have good credit and are responsible with credit cards, see if you can get a 0% credit card for 12 months, and pay off a large chunk of the debt up front. It can be very risky if your not responsible, but if you are, it can really pay off.
I used that method to get our of credit card debt about 25% faster than without using it.
Can you get health insurance? If so, that would be my first step. Their are some health insurances that will fly you back to the states in the case of an emergency. Therefore I would still recommend you put 20% away for retirement, then pay for health insurance and then any remainder, split between the student loans and your EF. I’d also start putting a little away for coming back to the states, that fund should not be your EF.
I would save for an emergency fund first, then put all you can towards paying off the student loan, especially if you are still in your late twenties. Your after tax return on paying off your student loan would be much better than if you invested it. Also, you can deduct $2,500 a year of interest paid. One final thing. I was wondering how investing pretax for retirement is better than investing after tax. My brother, a financial analysis, said there was no benefit. I didn’t believe him until I ran the numbers several times. Pretax you must pay tax on on the full withdrawals, but after tax you pay tax only on the earnings. Pretax you will have more when you retire but the burn rate will be faster because you have to take out more to compensate for the taxes being taking out of the entire withdrawal It seems you may actually come out ahead in the long run on after tax investment plus the money is liquid and avoids a layer of 401k, etc, fees. Maybe my assumptions are wrong. Can anyone dispute this? Just curious.
We struggle with the same issue (medical school loans at 4-5% interest rates versus retirement savings). We’ve made the decision to a little of both. Neither of our employers match funds (I would max that out if they did) and my medical school debt is currently $123K (started at $141K), making the “wait until the debt is paid off then divert the funds to retirement” plan unreasonable for us. It was psychologically important to us to start chipping away at the debt (despite my low salary as a resident) and also continue to save for retirement. I wish I could do more work to meet goals faster for both, but my income will also dramatically rise once I have finished my lengthy training (I’ll have 7 total years of training post-medical school) so I can hopefully do some catch up work later. The good news: we will be used to living on a my meager resident salary and will hopefully be good and continue to devote a huge portion of my (then much larger) salary to savings and debt.
Most of my colleagues do not pay down debt at all during residency (or pay just the interest to prevent capitalization). It would give us more retirement savings now but I just couldn’t stomach waiting until we’re in our mid to late 30s to start trying to get on top of that much debt. It’s so sad to pay such a large portion of my salary and see so little progress but I know that it really is making a difference… Also, keep in mind that if you are paying as much interest as I pay every year, most of that will not be tax deductible regardless of your income due to caps on the amount you can claim (I think it’s $2500).
One more thing: another reason I started paying down loans is that when I get to 36 on-time payments, I get a 0.5% interest rate reduction on my two largest loans. The sooner I get that, the more I save in the long run. Pay attention to any deals like that!
Pay down as much of your student loans as you can. Simple reason: student loans are generally non-dischargeable debt. If you get into financial problems due to unforeseen circumstances, your loans will not be dischargeable in bankruptcy except in very incredible circumstances that most people don’t qualify for (i.e. serious health issues that prevent you from working whatsoever.) I read stories about new graduates that can’t get jobs in this terrible economy. Their $100k+ student loans are deferred, but keep accuring interest–monthly payments become unmanageable.
Pay down your debt as soon as possible and then ramp up your investments later down the line. Return on investments in this volatile market isn’t worth it to put a lot into a 401k.
I recently quit my job to stay home with my newborn. I decided to cash out the small amount of money from my retirement. The money was to be deposited into my bank account, on the day the money was supposed to be there my ex-employer said the money had been turned over to gov. for student loans. Can I recover any of that money? Thanks.
I say pay off your student loan debt then invest in 401k. My reasons are as follows:
1. As long as you don’t pay off your student loans your bottom line figure is in the red. You’re not really worth anything until you’re in the black
2. Loans continue to grow interest. If retirement is a long term effort, its silly to not factor in the loss from long term loans
3. You and your husband already live in a precarious part of the world with no health insurance. If you want to continue this lifestyle its important to stay in the black as much as possible.
4. As you guys mature in your careers you will likely earn more, especially because you have the 2 masters degrees, therefore I’m confident you can catch up later by increasing your contribution as your salary increases and you remain debt free
I was faced with making a similar decision about a year ago. I am 23 with student loan debt and extra cash flow. Dealing with purely US taxes, I did the following in order:
1: Contribute enough to Traditional 401k to bring my W-2 income below $60,000 which allows me to deduct up to $2,500 of student loan interest in full. Any remaining moneys went to my Roth 401k which maxed out for the year ($16,500 in 2011 and $17,000 in 2012)
2: Contribute the max to a Roth IRA ($5,000 for 2011 and 2012)
3: Contribute to an after-tax investment account, call this the emergency fund.
4: Pay only monthly amount due of student loans as long as I can continue deducting the interest which makes my 6% loans effectively a 4.5% rate after deduction.
My reasoning is this: Cash is king, and my investments all earn more than my student loan interest rate. In an emergency, you can usually tap into the money tucked away in a 401k or Roth IRA. From the 401k, you can take a loan on the account and pay yourself back with interest. For a Roth IRA, you can take out your principal contributions at any time without incurring tax/penalty.
With a student loan, once you pay them, you no longer have the safety of cash. Also, with current talks of student loan reform, I would like to see how the next few years play out to see if there will be programs to reduce interest rate/principal on loans or something. And as a last resort, with all of the cash that I’m saving up, when it comes time to purchase a house, I can use my funds to make a serious down payment and then take out a home equity line of credit (HELOC) to pay off my student loans. Why? The interest paid on up to $100,000 of HELOC is currently tax deductible, so I would bypass the income limitation for student loans.
My wife(23) and I(25) are currently dual income, grossing $109,000. We have been out of college for about 18 months now, and are currently hacking away at our combined student loans/one car of $68,500(Originally $94,000). We are paying $3,000 per month to all loans, $1,400 of which is the minimum payment.
We really want to start a family, but I am not willing to do so until we pay down all of our loans and can survive off my military income(in case we decide she is going to stay at home).
We are currently maximizing her 401k matching program($172 monthly/$2,112 yearly), which makes her retirement saving double that at $4224/year.
I am currently contributing 10% to my TSP(a military 401k) which makes my retirement savings $424 monthly/$5,088 yearly.
What I am thinking of doing is keeping her matching the same(it would be stupid to throw away free money) and lowering my contributions to 5%, instead of 10%, giving us $200 more per month for loans. Also we would try to trim some savings else-ware($250). But the big problem is, how much will this hurt my retirement plan for the future?
As I said, we really want to get these loans out of the way, so we can focus on a family…Any suggestions?