February 10, 2023
So, you’re a recent college graduate, you’re finally starting to make a little real money and it’s time to make an important decision: should you pay off your student loans or start investing? There are a few things to consider before making that decision. Establishing your short and long term goals, how quickly you will be looking to purchase a house and are you preparing to get married or start a family? Are you a person whose goal it is to quickly become debt-free?
An important consideration is the interest rate on your loan. Federal loans frequently have lower interest rates than private loans and can come with benefits like income-driven repayment options. If interested in income-driven repayment, the rates vary, as does the repayment period and are directly determined by your income and family size. If your loans are less that 6%, financial experts support focusing on retirement and other investments first.
Federal student loan interest rates are often lower and are thought to be a more manageable kind of debt, and are sometimes called “good debt,” by financial experts. In general, debt that can be paid dependably, within the guidelines of the loan agreement is known as “good debt.”
Paying consistently on a student loan can create a favorable payment history that can positively impact credit scores and future financing needs. Other kinds of “good debt” are mortgages and a home equity line of credit (HELOC). Ask your tax preparer about the opportunity to deduct interest payments that you are making on your debt. Borrowers with federal student loan debt should should be mindful of congressional movement on the Biden administration’s student loan forgiveness plan. Though currently blocked, this legislation could make an impact on your decision making process.
If you have a private loan, and the loan’s interest rate is greater than 6%, many financial institutions recommend that paying off your loans prior to investing as it will yield a greater return on investment and avoid costly interest charges that can accumulate over time. Some financial experts recommend making two payments per month if your budget allows, or by allocating any end of year gift money towards your loan’s repayment.
It is critical to be aware of your debt to income ratio: How much of your earnings you have available after covering expenses in a given time period can both help you determine how to live within a budget and be mindful of investing priorities. Being prepared for emergencies and having liquidity or available cash in savings is another element of smart money management and future thinking. Financial advisors suggest building a few months’ savings to cover unexpected expenses.
In some cases, business analysts have noted that choosing to invest while repaying student loans could be a good option. An example of this would be if your loan’s interest rate is lower than 5%, your employer’s 401k plan is matching your contribution (assuming you are fully vested), and the expected return on an investment portfolio is greater than 10%.
Over time, this money, according to investment specialists, will most likely earn more in comparison to the what would be saved if you paid the loans off more quickly. In effect, you are paying yourself, since as your investment income grows it can be reinvested and multiplies. Known as compound interest, it is simply earning money from what you have already invested and in the opinion of many financial experts, one of the more compelling reasons to start investing sooner. By starting to save for retirement earlier, you will potentially have a greater impact on your savings since you are giving it more time to grow.
Identify your long term goals, meet with a financial advisor, and take the time to make a pros and cons list for this complex and nuanced decision.
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