Should I Pay Off Student Loans or Invest?

Recently, I received an email from Nate, a reader of The Simple Dollar. He was wondering whether it makes more sense to invest or to pay off his student loans:

I’m a regular reader of your site. I’m also a senior getting ready to graduate. I’m in an interesting situation and I was wonder what your advice would be.

I have quite a bit of extra money left over from my student loans, from living in a dump and living super frugal. One of my professors suggested that you could get a higher rate of return from investing some of your student loans. I’ve been thinking of doing this but I’m not certain.

When I graduate in the spring, I will have roughly 17k in student loans. Due to working, saving and excess loan monies I will have about 8k to either pay back towards my student loans or to invest. I know that the interest rate on my loans is variable but is about 7% currently.

I plan to make minimal payments to not allow compound interest. My future expected income is not that bad. I’m thinking that I could split up my monies into a safe low cost index fund and a more risky global emerging markets fund to diversify my risk.

Do you have any thoughts on this? Or is this out of your area?

Let’s boil down to the core of the question. I have $8K on hand. I also have $17K in debt at about 7% interest. Should I use the $8K for an investment or use it to pay down the debt?

If Nate chooses to use the $8K for an investment, he introduces some additional risk into his financial situation. In order to come out ahead of paying down the loans, Nate would have to earn a 7% return on his investment, meaning that he will have to invest in something with at least a bit of risk to it, such as an index fund. Over the long term, Nate should be able to top 7%, but what if Nate put in his money in January 2000, then looked at his situation in May 2002? His $8K would be quite a bit less (unless he was extremely lucky or happened to be in a hedge fund or something).

On the other hand, if Nate puts the $8K into his student loan, he nearly halves his monthly payment on his student loan. He can sit down with a calculator and his exact numbers to figure up, down to the penny, what the value of his $8K investment in early loan payments is.

There are two factors that Nate has going for him, though, that tell me that he should invest the money rather than pay off loans. First, he’s earning a degree from a prestigious school. When he walks out the door, he will have a top-notch education and a degree to prove it; this should provide a key into at least a solid paying job. Second, he’s young. At his young age, he has many, many years to watch that investment build up; his investment in the market would be for the long term. He also has more risk tolerance than many people because of his youth and independence.

Given these two factors, I would encourage Nate to invest his money in the market. Now, how should he invest it? He wants to diversify his investment in a relatively low-risk index fun and a high-risk emerging markets fund. Again, given his acceptable risk level, it is completely reasonable to adopt this investing philosophy. The exact proportions are a matter of discussion (there are arguments for putting it all in an index, putting it all in a risky fund, and anything else), but a balance between a steady fund and a volatile one is a strong place to put your money (for me, I’m at a place where I have lower risk tolerance, so I wouldn’t want to put significant money in a high-risk fund).

Nate’s getting his life off on the right foot no matter what he does. He’s already investing and looking at the future, instead of looking at the now-now-now-buy-buy-buy attitude of consumerism.

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  1. I’m not sure how much this will help, but the interest on his student loans are also tax-deductible, right? That kind of lessens the weight of paying the interest.

  2. Jim Kane says:

    It sounds like Nate has done a great job of living within his means throughout his college career, so I hesitated to write this; however, I hope he’ll consider an alternative point of view. Nate, when you took out that loan, it was for postsecondary education purposes (which explains your favorable interest rate, provided and guaranteed by the taxpaying public). To then use that money for personal gain seems unethical to me. I will now freely admit that I did exactly that ten years ago when I was a grad student, with one exception — instead of investing in stocks, I invested in a 21″ monitor. I won’t claim any special financial sense, but I hope you’ll think about the “personal” part of this personal finance decision (which has little to do with numbers). Also, in response to the previous commenter, the interest on your loan is only deductible if it’s used for postsecondary education.

    Maybe you can guess which course of action I’d recommend. :-)

  3. Kevin says:

    I am big on investing, but would disagree. However, my disagreement is based on only the facts stated, not his whole financial picture.

    Does he have an emergency savings with 3-6 months worth of living expenses? If not, he should put the 8k into an ING/HSBC online account (earning 4.35%/5.05% interest, respectively). True, he is paying more interest on the loan, but as mentioned above that should be tax deductible and the online accounts help remove the sting of the decision.

    More importantly, if something happens to his first job, he has a buffer — something most people these days do not have.

    If he has emergency savings, I would use the money to repay the loan by either sending in a massive payment, or again by putting it in online savings and paying out over time.

  4. Tax Deductions? says:

    In response to Jim Kane: “Also, in response to the previous commenter, the interest on your loan is only deductible if it’s used for postsecondary education.”
    Are you certain about this? My understanding (NOT a CPA, NOT a tax attorney) is that the student loan tax deduction is capped at a maximum $2500 deduction, for single filers who make $50K or less per year, then phased out for those who make up to $65K per year. I think that you are confusing tax deductions for student loan interest with HOPE credits and Lifetime Learning credits, which are a totally different matter. Check out: which has all the details.
    Nate should consider: the benefits of consolidating student loans, possibilities of receiving payment incentives reducing your student loan interest by up to 1.5 percent, the maximum amount that he contribute to an IRA during each tax year, and the possibility that a wonderful career might not begin the instant he leaves school or might require a potentially costly relocation, with accompanying deposits on housing. Nate may want to hang on to a buffer until works starts and he actually receives his first paycheck.
    Good luck!

  5. jake says:

    In response to Jim Kane.

    I disagree with you that using extra student loans for personal reasons is unethical. If you break down the fees of school and what FAFSA factors into how much you receive, they include “personal Costs”.

    Here is directly from my financial aid reward.

    Cost of Attendance:
    Fees
    Room and Board
    Books and Supplies
    Transportation
    Personal Costs

    The personal cost is there so that you have a life outside of study.

    Another way I myself look at it is this. It is a loan, which you pay back. If he had gotten free money for education and used that for illegal activities than I believe its unethical.

    When you look at it at an economic level, the money he is spending goes back to the economy which goes back to you and me in our pay checks. Again in the end he pays the loan back, so its a win win for everyone.

    Not only that, you do not factor in the education that he has invested in. This investment in education is not just personal it can possibly help everyone in society. His education can lead to high wages, which is taxed and in turn goes back to public programs. Because of his education level and with it high salaries in his life time he will pay back enough in taxes to make the spending on personal splurges irrelevant.

    Unethical? I don’t think so, if anything it helps society. He pays the loan back, and if he does use the loan to invest and gets profits that adds to the economy. In the end the money will be spent which will probably go to me or you in our paycheck, if not it will for our kids and their kids and so forth.

    Education pays.

  6. Nicholas Barry says:

    I’m about to start Grad school in the fall. I have a full scholarship, and I’m wondering if I should apply for student loans expressly for the purpose of investing.

    In this credit climate, I’m not sure if I can get a good rate, and even if I do, I’m not sure if investing in index funds would be wise, given the uncertainty of the market – if I get my loans, even if they’re interest-free while I’m at school, I might end up with less at the end of the two years than at the beginning.

    But if I planned on keeping the money in the market long-term, perhaps it would be wise to get started with prices low today, and just make loan payments out of my income. Do you have any advice?

  7. rodgerlvu says:

    I’m not sure how much this will help, but the interest on his student loans are also tax-deductible, right? That kind of lessens the weight of paying the interest thanks for your idea

  8. M says:

    Investing student loans is illegal. If he took out a student loan he cannot invest that money in the stock market.

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