How to Pay Student Loans and Save for Retirement

Recent graduates (and former graduates of all ages) may wonder whether they should focus on paying off their student loans as fast as possible or whether they should save and invest now that they are working and have disposable income. The best approach will vary from person to person, but in many cases the answer is probably both.

Some Caveats

Caveat one: You should always make the minimum payments on your student loans, as failure to do so can cause serious harm to your credit and can actually make it more difficult to ultimately pay them off. (For related reading, see: Student Loans: Paying Off Your Debt Faster.)

Caveat two: Being debt free has a psychological value - however, I do not account for that here. While you can easily quantify how much you will save by paying off a debt early, or how much you will have if you save/invest a certain amount and get a certain return over time, it can be nearly impossible to quantify any psychological value since it will vary from person to person.

What You Need to Consider

With that out of the way, focusing only on accelerating your student loan payoff at the expense of saving for retirement is almost always unwise. While each person's approach will vary, there are always some issues to keep in mind.

1) As a very general guideline, if you have student loans with an interest rate of 3% or less, it does not really make sense to accelerate payments to pay them off early. Why? Inflation.

The long-term, historical inflation rate has averaged around 3% (and has been around 3% or lower since the 1990s), so any debt at an interest rate of 3% or lower is going to have a real interest rate of roughly 0%, and in some cases, the real rate could even be negative. In other words, when you take inflation into account, debt at 3% or lower is essentially a “free” loan.

At the other end, if you your student loans have an interest rate of 6% of higher, you should definitely consider accelerating the payoff, and the higher the rate, the more serious the consideration should be. A student loan at a fixed rate of 6% or 7% may deserve a bit of extra attention, while a credit card charging 17% on a revolving balance deserves a lot of extra attention.

Finally, student loans with a rate between 3% and 6% are in a “gray area” in the sense that it might make sense to pay extra toward them, but it might not. Part of that decision is going to depend on what return you feel you can reasonably achieve over time elsewhere. In other words, getting a return higher than 3% to 6% on your long-term investments is well within reason with a properly allocated, well-diversified portfolio. However, there is no guarantee. Thus, student loans in the 3% to 6% range fall in the “gray area” that warrants additional analysis. (For related reading, see: Delay in Retirement Savings Costs More in the Long Run.)

2) In nearly every case, if you have access to a 401(k) with a company match, you should defer at least enough into the 401(k) to get the full match (though always keep caveat one in mind). A company match is the closest thing to “free” money that you will ever get and depending on how the match is structured, your immediate return on money you defer will often be between 50% and 100%.

No debt issued by a reputable lender will be subject to interest rates that high, so ensuring you get the full match should (likely) always trump paying extra toward debt.

3) If you do not have a company provided 401(k), then it is still worth considering a Roth or traditional IRA, which will provide a way to save for retirement in a tax advantaged fashion. The amount you can contribute to an IRA is lower than with a 401(k), but as we will see in point four below, time in the market is a critical component to long-term success, So simply getting started and building the habit of saving and investing is key.

4) Time in (not to be confused with timing) the market is incredibly valuable. While it might not feel like it to recent graduates, they are in the enviable position of having a long time before retirement, which means they have a long time for compounding to help grow their money.

For perspective, if you achieve a 7% annualized return, your money will double roughly every 10 years. For example, if you set aside $10,000 right now, never contribute another dime, and earn an annualized 7% return (which is not an unreasonable expectation over 40+ years if you put together a properly allocated, well-diversified portfolio and don't panic and make poor decisions along the way), after 40 years, you would have approximately $160,000.

All of this is to illustrate that the time you are in the market can help turn seemingly small amounts of money into large amounts of money, which reiterates the fact that recent graduates are in a fantastic position from a retirement savings perspective.

Student Loan Interest Rates

Student loan interest rates will vary depending on when your loan originated, the type of loan, whether it was a public or private loan, for undergrad or graduate school, subsidized or unsubsidized, etc. Over the last few years, interest rates on federal loans have ranged between roughly 3.75% on the low end to as high as about 7.25%. So the chances are that recent graduates' student loans will fall somewhere in between being in the “gray area” to being on the lower end of the range where it likely makes sense to accelerate payoff at least a bit.

Therefore, most recent graduates will want to consider the prospect of accelerating the payoff of their student loans, but they should always keep in mind that it is rarely going to be a wise long-term solution to focus solely on paying off students loans as fast as possible at the expense of saving for retirement.

So this leads us back to the original question of whether you should focus on paying off student loans as fast as possible or whether you should save and invest. And in most cases, the answer will be: you should do both. (For more, see: Are Student Loans Putting Your Retirement At Risk?)


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