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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