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Pay Off Your Student Loans Or Start Investing?

What’s the better choice?

Articles by Betterment Editors
By the Editorial Staff Betterment Resource Center Published Apr. 04, 2013
Published Apr. 04, 2013
2 min read

Students graduating this spring – and I am one of them – certainly have a lot to consider, but the decision to invest or pay down your debt shouldn’t be put off.

According to The New York Times, the average student graduates with $26,500 in student loan debt, but it’s really the type of debt you have that largely determines whether to pay these loans off as quickly as possible or pay just the minimum and invest the rest.

Types of Student Loans

Type of Loan Interest Rate Who’s Eligible
Direct Stafford Loans 3.4% (subsidized)6.8% (unsubsidized) Undergraduate and graduate students; limit depends on your year in school and whether you are an independent or dependent student
Direct PLUS Loans 7.9% Parents and graduate students
Perkins Loans 5% Undergraduate and graduate students with exceptional financial need; not all schools participate
Private Loans Varies Varies; interest rate generally set based on credit score and can be fixed or variable

Source: http://studentaid.ed.gov/types/loans/interest-rates

No longer your older brother’s payback scenario

Prior to 2006, Stafford Loans had a variable interest rate based on the 91-day T-bill rate + 1.7% during school and + 2.3% after school. In plain English, student loans had interest rates that were below the market’s long-term rate of return. With rates like these, the standard advice would be to pay your loans off slowly, invest the rest of your savings, and reap the rewards of returns being greater than interest rates.

If you’re lucky enough to have secured a loan at a rate of ~4%, you might be better off investing as much as possible and paying down as little as possible of that debt. Investments might yield 7-8% – so you can think of yourself earning a 3-4% spread on the money that’s been loaned to you and you’re investing (over the long term, and assuming average historic rates or return prevail). There’s no bright line here – the only thing that’s certain is that the earlier you start saving, the better.

However, while there are still some loans (e.g. Perkins loans) that have interest rates below long-term market returns, many other loans these days have interest rates that are equivalent or higher than market returns. In this case, financial aid experts recommend paying off your loans as quickly as you reasonably can, while still leaving money to pay your bills and enjoy your 20s.

Retirement… the one big exception

The one big exception to this advice is investing for retirement. The effects of compounding can be huge, so before we even think about student loan payments, we should put some money away for our golden years. And if you work at a company with 401(k) matching, you’ve got an even better reason to take advantage of the match and stash some money away.

It’s a personal decision

In the end, deciding how quickly to pay off your student loans is a personal decision. If you have other, higher interest debt; focus on paying that down first. And if you can’t stand having any debt and it’s keeping you up at night, pay off your debt as fast as you can and get some sleep.

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