Updated on 03.05.15

Balancing Act: Pay Down Student Loans or Save More?

walking a slackline in the park

Find the right balance between paying down student loans and saving for retirement. Photo: Jakub Michankow

You’re finally there: You’ve graduated from college after many hard years, you’ve got a job in your field, and you’re actually able to balance your budget so you’re not only paying your bills, but you have a bit of extra money left over each month.

Now the question is, what to do with that extra money? Despite the temptation of shopping sprees or making all those nights out with friends a little more exciting, the debate should most likely come down to either paying down your student loan debt or starting to save — for retirement, a down payment, or simply a larger emergency cushion.

If you’re like 71% of college graduates, you have student loan debt, which averages nearly $30,000 per graduate. Meanwhile, 41% of millennials worry about putting enough money away, and 20% aren’t saving at all, according to a survey reported in USA Today. The savings rate for people 35 and under has dipped to negative 2%, according to a Moody’s Analytics study.

Evidently, many of us could use some help with both student loan debt and saving. But if you’re fortunate enough to have found a job and have some extra money at the end of the month, you get to ask the question: What should I pay first?

There is no set answer to this question, and there is so much more that goes into figuring it out. Determining which approach works best for you requires understanding your financial situation and what you’re looking for in the future. Here are some things to think about:

  • Your student loans: What are the terms of your loans? What is the interest rate on your loans? Can that interest rate change (i.e., is it a variable interest rate)? Can you qualify for loan forgiveness?
  • Your other debt: Do you have credit cards debt or a car loan? If so, what is the interest rate of these debts?
  • Your monthly income, expenses, and budget: What is your take-home income each month? What are your fixed expenses, including your monthly minimum payments for any student loans?
  • Your savings goals: Establish your short-term and long-term savings goals. Find out whether your employer offers savings incentive programs, like matching 401(k) contributions.

Now that you’ve got your information, you can start to consider what to do with that extra money. There are two sides to the story, as is so often the case, and there are pros and cons to each possibility. Let’s explore both options.

Paying Debt First

Student loan debt can weigh on you. Studies have shown that many graduates carrying student loan debt have put off buying a home, getting married, and having children.

Articles like “How I paid off my student loans at 26,” with graduates sharing their stories on how they became debt free, might inspire you to put every extra penny toward those student loan debts.

But whether that’s the best idea comes down to a few different scenarios. Most financial experts will simply tell you it’s about the numbers.

Pros of Paying Down Student Loan Debt First

If you’re putting your extra money into a savings account that’s earning 2% interest, while only paying minimums on a private student loan that has a 10% interest rate, you’re paying way more on that loan than you’re earning in interest from a savings account. In that case, it may make more sense to pay down that loan before saving.

Young Money recommends paying down any student loans with an interest rate of 8% or higher, since 8% is the “long-term investment return on the stock market,” according to the article.

Mint.com suggests that keeping your student loans around can be a risk if you lose your job. There is also the possibility of your interest rate going up if it’s a variable interest rate.

While it might not hold much weight to many people, paying down the debt can also result in an improvement in your emotional and psychological well-being, increased self-esteem, and improvement in your relationships, according to Bankrate.com.

Another pro to keep in mind is that any interest you’re paying down on your student loans is tax-deductible, up to $2,500.

Don’t Forgo Saving Entirely

Let’s set the scene: Your student loans have a high interest rate, and you’ve decided to put your extra money toward these loans. Or you decide to rid yourself of student loan debt. That isn’t necessarily going to be your first step.

  • Emergency fund comes first: If you’re going to tackle your student loans, Bankrate recommends continuing to pay the minimum on your loans until you have 12 months’ worth of basic living expenses in an emergency fund before you pay anything extra on a loan. You want to be prepared in case you lose your job or have another financial emergency.
  • Other high-interest debts: Don’t forget any high-interest credit card debt you have, or a high-interest car loan.
  • Get the match: It’s always a good idea to take full advantage of your employer’s 401(k) program, especially if the company matches your contributions. This is essentially free money and amounts to giving yourself a raise.
  • Pay toward principal: Before you pay anything extra, confirm with your lender where that payment is going. Some lenders take anything extra and apply it toward a future payment instead of knocking down the balance. You want the extra payments to be applied to your principal, so you’ll pay down the loan faster and pay less in interest overall.

Saving Before Paying Debt

Earlier we mentioned the CNN article on a woman who paid down her student loan debt by age 26. In response to that article, a young man wrote a post titled, “Want to get rich? Don’t pay off your student loans.” While in the midst of paying down debt, he asked himself why rush to pay student loans with a 3% interest rate “when the S&P has historically returned 11%.”

Pros to Saving First

If your student loans are at a lower interest rate, you may be able to invest your money in another way that would result in more money over time.

Besides investing, many experts advise you to save your money and build an emergency fund before making extra payments toward student loans. If you’re forgoing this safety net to pay down loans, you’re going to be in a bad situation should you lose your job or experience another financial hardship.

Carrie Schwab-Pomerantz, Certified Financial Planner and senior vice president of Charles Schwab & Co., recommends, first and foremost, taking full advantage of any employer match program.

Then the financial expert recommends paying off car loans or credit cards, starting with the highest-interest debt, followed by building an emergency fund. After that, she says, start saving at least 10% of your gross salary for retirement.

After you get that down, she recommends saving for a child’s education, saving for a home, and only at that point paying down other debt — including extra student loan payments.

Daily Finance seconds the notion that saving for retirement should come before paying down student loan debt. It recommends always taking advantage of any tax deductions and free employer-matching contributions; they’re going to be well worth any extra money you would have been putting toward your loans.

Increasing your savings before paying down debt would allow you to save for retirement. Say you graduate at 22, start paying extra toward your loans, and forgo saving for retirement until age 30. You can’t get back those years to grow your savings and compound your investments.

Another thing to consider is that you may end up qualifying for some type of student loan forgiveness down the road, which would cancel some or all of your loan balances. You never know where your career might take you, and you might find a job that offers loan forgiveness. This could also be an option depending on where you move, if you do volunteer work, or join the military. If you qualify for an income-based repayment plan, in some instances, your loans are then forgiven after a certain amount of time.

What About Medium-Term Savings Goals?

So we know the importance of starting an emergency fund and saving for retirement before paying down low-interest student loans. But what about your medium-term saving goals? If you’re planning on taking a vacation in a year, but put all of your money toward your student loans, what happens when it’s time to pay for that vacation? If you’re throwing it on a high-interest credit card, you’re going to end up paying a lot more for that trip than if you would have saved for it instead.

Another medium-term goal would be saving for a down payment on a home. If owning a home is something that could save you money and be a possible investment down the road, paying all extra money towards loan is going to take that option away.

If you decide you want to invest or save before tackling that student loan debt, you must always continue making your minimum loan payment on your student loans. You can’t just forgo paying them in order to save. If you’re going this route, treat your loans as part of your imperative monthly payments, like rent and utilities.

Putting your loans in forbearance or a deferment isn’t necessarily the play to increase your savings either. Your loans are going to continue to accrue interest during these periods.

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