Which is the right move? Paying down student debt or saving for retirement.
Recent college graduates know that paying down student debt and saving for retirement are both important. But you won't retire for decades, and you've got loan payments coming due now — why not just pay off debt? It might surprise you to discover it's not as straightforward as it seems when you're thinking long-term.
If you have loans with low interest rates, making the minimum payments and putting your extra funds towards a 401(k), traditional IRA, or Roth IRA could make a huge difference when you retire.
Getting started
As you consider your options, be sure to understand the type of loans you have and their repayment plans. Assuming you have extra cash each month, consider the following when deciding whether to put it toward increasing your loan repayment or starting to contribute to retirement savings via a 401(k), traditional IRA or Roth IRA.
Figuring out your priorities
Your financial goals will depend on your situation. At different points in your life, it may make sense for you to focus on paying down debt, saving for retirement, or putting money toward everyday costs.
An example on how to evaluate your goals:
Let’s say you’re a 25-year-old who landed a $40,000-a-year job.
- Your job offers a 401(k) with a company match of 50 percent of your contributions up to 6 percent of your salary. You're expecting it to grow 7 percent per year.
- You have $30,000 in a combination of student loans with a 25-year term and a $193.29 monthly payment.
After creating your budget, establishing an emergency fund, accounting for minimum loan payments and saving 6 percent of your income toward a 401(k) to get your company match, you discover that you have $200 extra each month to put toward your loans or retirement accounts. What you do next will depend on your financial goals. Below are some example goals that can help you decide whether to go with a retirement-focused approach or a loan-first approach.
Goal: Maximizing financial gains
If you want the most money possible when you retire, invest as much as you can as soon as you can. In the hypothetical situation described above, putting aside $200 extra per month means having over a million dollars in your account instead of just under $750,000 with your existing 6 percent investment.
Goal: Hitting a retirement savings goal faster
You might want to front-load your retirement savings so your money has more time to grow. Contributing extra money towards your retirement account now could let you accomplish a goal like having $100,000 saved by the time you're 40.
Goal: Eliminating the stress of owing money
The thought of making loan payments for 10 years or more can take a toll on your mental health. Paying off your loans as fast as possible with a loan-first approach removes this stress. In our example, adding the extra $200 to your loan payoff will be the difference between making payments for 25 years or 8.
Goal: Improving your credit score.
Taking care of your student loans early with a loan-first approach would reduce your credit utilization, potentially improving your credit score and making it more likely you get a lower interest rate on future loans to achieve goals like a graduate degree or home purchase.
Goal: Maximizing cash flow
Life can get expensive. Unexpected bills like car repairs or medical expenses may make it so you need to focus on just making the minimum payments on your student loans and retirement contributions, and using the extra $200 for monthly expenses.
Setting expectations
In most cases, putting money away for retirement early will mean a lot more cash in your pocket later in life. But if your student loan payments are keeping you from accomplishing your current financial goals, like saving to buy a home, or just simply taking too big a bite out of your paycheck every month, there's nothing wrong with prioritizing paying them off. By evaluating your options and making a plan, you can feel confident that the path you're on is the right one for you.
