Head vs. Heart
Over the next few months, federal student loan borrowers whose loans have been in forbearance since…I have lost count of when…will begin to receive notices that payments will resume shortly.
And with those notices will come the time-worn decision: Which comes first? Paying down debt faster or saving for retirement? This brings to mind an academic research piece that I came across a few years ago. In a survey of young adults, researchers found that almost 40 percent were postponing saving for retirement in favor of another financial goal. Quite often, this goal was paying off student loans.
The Puritan emotional appeal is clear. But does it make sense to forgo retirement saving completely to prioritize student loan debt?
Today the average federal student loan debt is about $40,000. Assuming an interest rate of 6.50%, under the new standard repayment plan (available as from July 1) one could expect a minimum monthly payment of about $350 for 15 years. But you are an overachiever and you can dedicate an additional $200 per month to the payment! Not only does this reduce the overall amount of interest that you pay by about one-half, you will also complete your time served in student loan debt about six years earlier. What’s not to love?
Well, what if that $200 extra came at the expense of a retirement account contribution? You can do one or the other, but not both. I don’t think I need to run you through the math here. If you expect an investment rate of return greater than your student loan interest rate, then your best mathematical play is obviously to invest. And in the not-so-distant past of exceptionally low interest rates, the answer was obvious. But with a 6.50% interest rate (about average for outstanding undergraduate school loans), today that argument could easily go either way. Also, who’s to say that today’s outsized stock market returns will last in perpetuity? Not I.
Now if your $200 retirement account contribution is matched one-to-one by your employer, or even 50 cents for every dollar contributed, that’s a 50% or 100% rate of return at the start. Case closed; you know what to do.
But what if you don’t have an employer match (making the retirement account the obvious choice) and the interest rate vs. investment rate comparison is ambiguous? I still want you to show your retirement account some love. Here’s why:
Successful saving is a habit, and the earlier that you commit to it, the easier it is to maintain the practice over the long term. You know that.
Here’s the other reason. In the first draft of this blog, there was quite a bit of math illustrating the possible economic trade-offs between the two choices. But sometimes personal finance is a bit of a slog. While there is certainly satisfaction in working toward the goal of being debt free, it likely does not warm your heart on a daily basis. Honestly, it’s a chore. On the other hand, it is inherently optimistic and may even feel joyful to direct your money to a positive vision of the future. The path to financial wellness should fill you with a sense of, well, wellness.
Yes, that hypothetical $200 would be very well spent on extra monthly loan payments. I cannot find fault with that decision. But I would argue that you can feed both your mathematically inclined head and your heart by directing that amount, or at least a portion thereof, to the unknown possibilities that await you.
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