It’s difficult to know where to put a few extra bucks at the end of the month, especially for graduates who are trying to balance student loans, retirement savings and other expenses without coming out behind in one category or another.
But according to a Motley Fool report, although paying off student loans faster may look as if it’s the obvious choice, the smarter move may be putting that extra money (or part of it, anyway) into retirement savings.
Oh, and then there’s the little matter of an emergency fund…
Anyway, aiming first at those college loans can result in a lower debt load, smaller interest payments and getting the albatross off your neck—but putting the money there, rather than into a retirement account, can result in a retirement fund that’s way smaller than you might need when you’re old enough to draw on it.
As an example, the report says, a Jane Doe with a minimum monthly payment of $330 on $50,000 worth of college loans, with an interest rate of 5 percent and a term of 20 years, figures that with the $1,000 she has left over after the minimum payment and all her other expenses she can knock that loan debt down much faster and save herself a bunch of money.
Paying on the loans for the full 20-year term, at the minimum monthly payment, will take her 240 months to clear the debt, while costing her $29,195 in interest.
Should she add $500 to that minimum, she can pay off the debt in just 70 months, only paying $7,693 in interest, and if she plunks down the whole $1,000 in addition to the minimum it will take just 41 months to pay it off and cost her only $4,493 in interest.
But… (you knew there would be a “but,” didn’t you?)
If she took that extra $1,000 and sank it into a retirement account instead—over the whole 20 years of the term of her college loans—she’d end up with $589,020 at the end of the 20 years, figuring an average return on her investments of 8 percent per year, while at the end of 40 years that investment account balance would total $2,745,397—a pretty hefty difference, because the account started growing so quickly at the very beginning.
Investing the $500 she’d have left if she put only an extra $500 into the college loans, then increasing the investment to $1,330 once the loans were paid off at the end of 70 months, at the end of 20 years she’d have an investment account balance of $555,283—not hugely different from what she’d have at the end of 20 years in the first scenario. But, at the end of 40 years, she’d have $2,588,010—a much more substantial difference.
And in scenario 3, if she invested nothing for the first 41 months and only started saving for retirement when those loans were completely paid off, she’d have $549,005 at the end of 20 years and $2,558,888 at the end of 40 years. The compounding of the extra money at the beginning in scenarios 1 and 2 beat the results of scenario 3.
Of course, there’s no guarantee of an 8 percent return on investments, although over time it’s fairly consistent—with the S&P even recording a 7 percent return since 2007 (and including the Great Recession).
But if you’re not risk tolerant, that might not work for you, since you a) have to have the nerve to ride it out and b) have to have chosen investments that will keep chugging along.
Other considerations the report points out are the need for that emergency fund, with at least enough for six months’ worth of expenses, and the need to at least contribute enough to a retirement plan to get 100 percent of the employer matching funds, since that’s free money.
While not everyone’s priorities are the same, these factors are all important in reaching the final balancing act—how much to save for retirement and how quickly to pay off student loans. Only you can choose which balance feels right for you.