Why You Might Not Want to Pay Off Your Student Loans Early
If you pay attention to most financial experts, a common refrain you'll hear is "get out of debt." And to a large extent, this is absolutely true, particularly if it's high-interest debt, like credit cards and debt consolidation loans. In that case, pay them off as quickly as you can.
But if you have student loans, you could be making a mistake if you're aggressively paying them off. This is especially true if you're not maximizing your savings for retirement, haven't established an emergency fund, or considered all of your long-term financial goals. Let's take a closer look at the three biggest reasons why paying off your student loans early might not be the best call.
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If you don’t have a safety net
Paying off debt and reducing your expenses will go a long way toward your long-term financial success. But if you're paying extra on your student loans and don't have an emergency fund, that could be a painful mistake. As a good rule of thumb, set a goal of saving six months of expenses. If you own a home or have children, start working toward having a full year of cash savings.
Yes, interest rates on savings accounts are terrible today, but it's important to remember that your emergency fund isn't for getting a return — it's for protecting your family and your assets in a worst-case scenario. You can't predict the unexpected like a car accident, losing your job, or illness. But you can plan for it by building your cash savings to help you ride out the unexpected.
That money can go a lot further if you invest it for the long term
The allure of paying of that student loan a few years early may feel really good, but if you're doing it by neglecting to maximize your retirement savings, you're actually doing more harm than good to your financial future. There are a few reasons why, starting with a very simple term: return on investment. Let me explain.
In short, you almost certainly can capture a higher return by investing that money in a Roth IRA or 401(k) at work than you'll save in reduced interest by paying off your student loan early. For instance, if the interest rate on your student loan is less than 7% per year — which a significant number are — the odds are in your favor by investing that money in a low-cost S&P 500 index fund.
Historically, the S&P 500 has generated average annualized total returns around 10%. Yes, there will be down years and months, but if instead of paying more toward that low-interest rate loan you're contributing extra income to your retirement investments, you should come out ahead over the long term.
Here's a simplified example. If you plan to pay an extra $3,000 per year above the minimum over the next 10 years on your student loan with a 7% interest rate, you'll avoid about $8,000 in interest. But if, instead, you contributed that same $3,000 per year into retirement savings and captured the stock market's higher rate of return, that $30,000 in total contributions could be worth around $44,000 in a decade and $300,000 or more in 30 years. And if you're contributing to a Roth IRA, all of your gains will be completely tax-free when you take distributions in retirement.
Time is your most valuable asset for generating compounding returns. Take advantage of the low interest rate on your student loan and instead contribute more to your retirement plan — and you almost certainly will come out way ahead.
You could be missing out on far more money than you’re saving in interest
If you're putting off saving for retirement completely to pay off that student loan, you're missing out on two potential sources of bonus money: employer matching contributions and reduced income taxes.
Most employers offer a matching contribution to your 401(k), and it's almost certainly worth a lot more money than the interest you pay on student debt. For instance, if you make $50,000 per year and your company matches 50% of your 401(k) contribution up to 3% of your pay, you'll receive $750 in free money just by putting $1,500 per year in your 401(k). That same $1,500 toward a student loan with a 7% interest rate only will save you about $105 per year in interest.
It gets even better. Every dollar you contribute to your 401(k) is considered pre-tax income. If you make $50,000, a $1,500 contribution would save $330 in federal income tax, based on the 22% marginal rate for 2018. Tax savings and matching contributions combined would net you almost $1,100, 10 times more than the $105 per year you'll save in interest on your student loans. And that's above and beyond the potential for higher returns as discussed above.
Debt can be the enemy, but it’s also a handy tool
High-cost debt can be wealth-destroying and should be paid off as quickly as possible. But responsible use of lower-cost debt, like student loans, a mortgage, or an auto loan, can actually help you grow your wealth over the long term since the amount you'd pay in interest is often lower than the long-term returns you should be able to attain by investing in stocks.
Lastly, the value of maintaining a safety net of cash should not be underestimated. Hopefully, you'll never need it. But if you do, it could make all the difference between a quick recovery and long-lasting financial hardship.
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