Over 40% of people under 30 are currently making student loan payments. That’s a staggering number. And while we often think of how these payments affect our current financial picture (I certainly know how it feels to see that withdrawal come out of my account every month!), the effect on our financial future is very much overlooked.
Simply put, how will our student loan payments affect how much we save for retirement?
Well, that’s not a hard question to answer. If we can’t save as much now, we’ll have less later. Thanks for that, Bill.
Fair enough. Let me rephrase the question. Say you are at a point in your career where you have some flexibility in your budget. Even after you’re making your loan payments, you’re still able to save for retirement each month.
The question then becomes- is it better for you to pay down you loans quickly by making more than the minimum payment, rather than putting that money into a retirement account?
That’s a much more interesting question. Let’s take a look.
Earlier this year, HelloWallet (a Morningstar-affiliated company) produced a report on the relationship between student loan debt and retirement. The results, while not unexpected, were alarming. They found that student loan balances directly correlated with having less money to spend in retirement.
HelloWallet even puts a number on it- for every dollar in student loan debt you owe, you’ll have $0.17 less in retirement. Financial guru Clark Howard (one of my biggest influences) extrapolated from the report that because of the negative effects student loans have on retirement balances, “… in most circumstances, it’s better to save more for retirement than pay extra toward your student loans…”
Generally speaking, they’re right. If we are just looking at two goals- paying off your debt versus saving for retirement- most borrowers will come out ahead in retirement if they make the minimum student loan payment every month now and put their excess savings toward retirement, rather than trying to pay off the student loan ASAP at the expense of retirement saving.
It’s All About Compound Interest
What to do with the money you save each month comes down to the rate you earn and the length of time you are saving. Investing more for retirement early in your career has exponential benefits to the money you’ll have available at retirement.
Take a look at the numbers. The chart below shows how much you’ll have at age 65 if you start saving $100 a month at certain ages, assuming a 6% growth rate:
Notice anything? Take a look at the difference in retirement values if you start saving at age 25 versus age 30. For the 25 year old, over 25% of the account value at retirement comes from the $100/month invested between ages 25 and 30!
This idea of compound interest clearly illustrates the perils of paying down student loans at the expense of your retirement savings. The earlier you start saving for retirement, the exponentially better off you will be when it comes time to retire. The degree to which your student loans impact your saving will directly impact your retirement picture.
Let’s take a look at an example.
Sarah is a 25 year old lawyer who is hoping to retire at age 65. She has a total of $25,000 in loan debt (point taken, after 3 years in law school, she probably has a lot more than that, but let’s keep the numbers easy to work with, OK?) and is on a standard 10 year repayment plan, paying $265.16 each month. Her loans have a 5% interest rate.
On top of these loan payments, she’s able to save $200 extra per month to put toward retirement. Once she’s done paying off her loans in ten years, she will put that extra $265.16 toward retirement as well, increasing her total monthly retirement savings to $465.16. Sarah’s retirement savings earns 7% a year (about what the stock market has historically made on average).
Sarah is wondering whether or not she should continue to save $200 dollars per month for retirement now, or whether it might make sense for her to, say, put $100 of that money each month as an “extra” payment on her student loans to pay off the loan faster, and keep contributing the remaining $100 toward retirement.
What’s Sarah’s Best Option?
In the first scenario (saving $200 a month), by the end of her 10 year loan payment period, the loan is paid off and Sarah has ~$35,000 saved for retirement. She then increases her payment amount as scheduled, and by the time she retires, her retirement accounts are worth $853,399.48. Not too shabby!
But, what happens if she uses half of her monthly savings to pay off her loan faster? She is able to pay off her loan in just over seven years, and the second she pays off her loan, she increases her retirement savings per month from $100 to the full amount of $465.16. Even though she’s able to contribute more over the first ten years in this example, take a look at her retirement account value. She only has $823,844.59 at retirement this time.
This is a great example of the power of compound interest. The more Sarah starts to save for retirement today, the more she’ll have at retirement. Even if she has to pay a higher amount on her student loans.
Again, there are a lot of factors at play here. Not everyone is in the same position as Sarah. This example doesn’t take into account a few points:
- If your situation is an outlier, I’d recommend crunching the numbers to evaluate the strategy before you make a decision. What do I mean by outliers? Cases where one of the factors we are looking at is either very high or very low. For example, If you have a very high student loan balance, or very high interest rates, or are a very conservative investor (ie, you might not want to invest in a way that will lend itself to a 7% annual growth rate as identified above), carefully evaluate these factors before making a decision.
- Of course, in this post we’re only looking at two goals: paying down student loans and retirement saving. If you have multiple goals you’re trying to save for at once, a more detailed plan is needed. In particular, if you are weighing paying down student loans quickly versus a more near-term savings goal (ex: buying a house in five years), this decision is much less clear cut and needs to be evaluated.
- This whole exercise assumes that you can afford to save beyond your monthly budget. If you can’t, definitely make the minimum payments on your loans. In addition, you should review whether an income repayment plan may be a good fit for you. Finally, review your budget to see if there are any ways to trim back on spending or increase your income.
- We haven’t even addressed that most employers offer a match on funds that you invest in your 401(k). If your employer matches, putting extra money toward your loans at the expense of retirement saving becomes even costlier. Employer matches on 401(k)s are the closest thing out there to free money, after all!
- Most importantly, Sarah in the example above is incredibly disciplined financially. Not only is she diligently saving $200 a month (either in her retirement account, or split between retirement savings and making payments on her loans), but she also has the discipline to redirect her entire student loan payment amount into her retirement savings the second her loan is paid off. This is much harder to do in practice than it is on paper, so it’s important to plan ahead and hold yourself accountable.
A Word on Interest Rates
Interest rates on student loans vary wildly. Some can be as low as 2-3%, others can be in double digits.
Like I mentioned earlier, the average return in the stock market has historically been about 7%. If your student loan interest rates are higher than this, it’s not a bad idea to prioritize payments to pay down the high interest rate loans first.
Particularly if these high interest rate loans are private loans, refinancing into a lower rate loan is a great option for those who have good credit scores. For more information on this, sign up for my newsletter to download a free copy of my eBook on student loans.
There’s some good research out there that recommends to usually save for retirement before making extra student loan payments. Don’t take that as the gospel truth, but generally speaking, this approach is the correct one. In most cases, the benefits of having money in your retirement account to compound in value over time will outweigh having to pay your student loans a little bit longer.
Carefully look at your personal budget, student loan balance, interest rates, and retirement goals to make these decisions. And don’t be afraid to reach out to an expert for a second opinion.