Young people who have just graduated college and are starting their first job are confronted with a tough decision: how to balance paying off student loans with saving for retirement in an employer’s 401(k) plan.
Like with all financial decisions, the best approach can vary from person to person, but in this case, we do have some general recommendations.
Paying Down Debt vs. Saving: The Mathematics
It is important to remember, on paper at least, paying down your debt to avoid accruing interest, or saving and investing to receive a return are functionally the same thing.
If you use $100 to pay down debt that is accruing at 5%, thus saving you 5 dollars of interest, you are $5 better off. If you were to instead use that same $100 to invest and receive a 5% return, you are 5 dollars better off. Though one involves saving $5 in interest and the other involves earning that $5 as an investment return, it is functionally the same thing.
With a finite amount of money to go around it is mathematically optimal to put more of your dollars wherever you get the highest rate, whether it be saving on interest or receiving a return as an investor
When the gap is large the decision is obvious – for example an investment that returns 10% vs. paying down a mortgage at 3.5% interest. If you have credit cards accruing interest at upwards of 22%, it is probably better to pay those off than invest at 10%.
Paying off Student Loans vs. Saving for Retirement
With student loans the gap between the numbers isn’t very large and people often have different loans with different interest rates.
Interest rates on student loans can vary based on the type of loan, and can be anywhere from the low 4% range to the mid 7% range at the higher end. The interest rate on your debt serves as the hurdle rate an investment must beat to make you better off investing.
I recommend young people invest their money in 100% stocks for retirement – (for the reasons why read my CNBC article: This 29-year-old financial advisor puts his money where his mouth is by investing in 100% stocks) and since just about every 401(k) I have seen has a good S&P 500 index fund option, let’s consider this the “opportunity cost” as far as paying down debt vs. investing for retirement. The average return on the S&P 500 is around 10% going back to 1926, since 1957 (the year it expanded to cover 500 stocks) it has been around 8%.*
But there is no guarantee that the next period of time is going to produce average returns. There is always a chance returns could be lower than even the lowest or student loan interest rates.
This is why if their student debt is accruing at a rate closer to 7% or 8% I have an easy time just telling people to pay off their debt first. But faced with the choice between saving 5% or 6% interest on your debt vs. the chance of receiving 8% - 10% for investing (but possibly considerably less), which do you choose?
In these situations, instead of belaboring the statistics to see what percentage of the time the S&P 500 would have returned a higher amount than your interest rate over the period of time you are considering, I think it is better just to think about the emotional, human side of having less debt vs. having retirement savings.
The Human Side
Though on paper paying down debt vs. saving in a 401(k) could be a purely mathematical decision, in real life there are practical elements to the decision that I think take priority over the numbers.
Student debt often feels like a monkey on people’s backs – the constant feeling of being “in the hole” can be oppressive. It hangs over their personal finances like a dark cloud, which makes it difficult to celebrate any other financial successes that occur in life because they feel like moving pebbles relative to the boulder that is their student loan debt.
For this reason, regardless of what the numbers say, it may be better for someone who is very stressed about their debt to pay down their student loan balance and get the mental reward of doing so, which will eventually turn to lasting peace of mind once the debt is paid off.
My job as a financial planner is more often to prevent people from acting on emotion and pursuing a course of action just because it makes them feel better, and I don’t want anyone to think I am an enabler of bad habits by suggesting someone pursue a path that is mathematically “sub-optimal.”
But given the choice between financial empowerment or financial frustration as people start taking responsibility for their own financial well-being, the first option certainly is more likely to reinforce good habits and set someone on a path to financial success.
So I generally have no problem telling people to prioritize paying off their student loans and worry about saving for retirement later.
However, the other very important practical consideration in this decision is whether or not you receive an employer match on dollars you save for retirement in an employer’s 401(k) plan, which can shift the numbers in favor of saving enough to get the full match.
Make Sure to Save Enough to get your Full Employer Match
Many employers will offer to “match” a certain percentage of the amount you contribute to your 401(k) and contribute to your account on your behalf. This is literally free money that should be taken advantage of to the fullest extent possible, even if that means putting less towards student loans.
If you get a dollar for dollar match on a certain amount of your contributions, that is like receiving a 100% return on the dollars you put away for retirement immediately. If your employer matches 50% of your contribution, that is an immediate 50% return on dollars you save for retirement. Even high-interest rate debt can’t compete with that.
Employers will generally only match up to a certain percentage of income, and in my experience you usually don’t have to contribute a huge amount of your salary (under 7%) to get the full match. In some cases, even saving 1% or 2% will enable you to receive a generous match and save a few percent of your income that you wouldn’t have been paid otherwise.
So my general recommendation, if I dare to make one in the complicated world of personal finance, is for people who are deciding between paying off student loans and saving for retirement to contribute enough to get their full 401(k) match, and use the rest to pay down their student debt.
Special Matching Provisions for Student Loan Borrowers
Companies have recognized that student loans are the number one reason people don’t contribute to their 401(k) plans and many are taking steps to help.
Just recently, companies like Abbott Laboratories and Travelers Companies started rolling out programs where the company would make matching contributions to an employee’s 401(k) account based on that employee’s repayment of student loans to outside organizations. The IRS approved these programs with a private letter ruling, though there is no blanket law for these programs yet.
Though this program is new, it offers such a huge benefit to young employees who are likely to be saddled with student debt, I wouldn’t be surprised to see more companies adopt similar programs. As these programs become more common, it may be smart for people with a lot of student debt to seek out companies that provide this as a benefit when they search for jobs.
For more info on student loan matching program, read this US News article featuring comments from Ruedi Wealth Management Financial Advisor Ryan Repko, CFP®: How the New IRS Rules Affect Student Loan Benefits.
Keep the Habit After the Student Debt is Gone
Though it may seem far away now, eventually your diligence will result in completely paid off student loans. At that point, you may think you’ve got it made and that the need to be financially responsible is over, but you may still just be getting started and need to keep your same responsible financial habits.
Once you have paid off the debt, do not think of what you were paying towards your debt each month as money you are now free to spend. If you prioritized paying off debt instead of saving for retirement, it will probably be beneficial to play catch-up as far as retirement savings.
Since you already have the habit of putting a certain amount of money towards loans each month, my recommendation is to simply keep the habit, but just put that money towards saving for retirement or other financial goals.
Final Thoughts: Don’t Delay
With both paying off student loans and saving for retirement, there is a huge benefit to starting early.
Debt can drag on and before you know it a decade has passed and you’ve only made interest payments. That is bad from both a financial and emotional standpoint, as you will feel like you were just spinning your wheels the whole time you were working and making payments.
It is vitally important to save for retirement early as well, so the money you save has time to experience the staggering compound returns of the stock market. Once the years have passed, you have missed the opportunity to have your investments grow over that time period, and you will never get it back. Missing out on the early years of saving generally means considerably more saving later in life to play catch up.
Paul R. Ruedi, CFP® is a financial advisor at Ruedi Wealth Management in Plano, Texas.
Paul has been quoted in news publications including USA Today, Forbes, The New York Times, Dallas Morning News, Inc.com, Business Insider, US News and World Report, GoBankingRates, The Street, NerdWallet, and The Penny Hoarder. He also writes articles that have been featured in CNBC, Investopedia, Yahoo Finance, Nasdaq, and MSN Money. He was named one of Investopedia's Top 100 Most Influential Financial Advisors in 2018.
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