The average college student graduating with loans in 2015 faces around $35,000 of debt. The idea of planning for retirement straight out of college sounds like a distant dream. I’m a big advocate of long-term financial planning at a young age, but when I bring up retirement savings with friends, they say they plan to put it off until they’ve finished repaying their loans or accomplished other goals. That’s not necessarily a good idea.
Here’s why: let’s assume that after you make minimum payments on your student loans, plus other expenses, you have an extra $100 at the end of the month—or $1,200 at the end of the year. If you put $1,200 into index funds in a retirement account like a Roth IRA, that money will grow tax-free for the 40-something years before you retire. At an 8% growth rate over 40 years, that $1,200 will turn into over $26,000. Pretty cool, right? This year-over-year growth is the power of compound interest.
Now, say you decide to put that extra $100/month toward paying off student loans. Getting rid of student loan debt early sounds pretty great, and if your loans have an interest rate over the 8% used in the example above, you’re probably better off making those extra loan payments.
This is because the absolute amount you will spend repaying student loans surpasses the absolute amount you can gain by investing that money. If your student loan interest rate is 10%, contributing an extra $1,200 this year saves you from paying over $5,000 in interest over the next 15 years. Investing that $1,200 over the next 15 years at an 8% interest rate will only yield about $3,800 in interest. So by prioritizing student loans, you save yourself an extra $1,200 over 15 years.
The easy way to remember this rule: if your highest student loan interest rate (10%) is greater than your expected return in the stock market (8%), you should prioritize student loans. If your student loan interest rate is relatively low—3.5%, for example—you’re better off investing that extra cash in retirement. Remember that interest on student loans is often tax-deductible, further which lowers its effective cost. Somebody in the 25% tax bracket would have an effective cost of 3.5% interest on a Stafford loan with a 4.66% interest rate, because they are using pre-tax money to pay that interest.
A note: if your employer offers a 401(k) with company match, that’s free money on the table—take it. After making minimum student loan payments, of course! A common policy is dollar-for-dollar 401(k) matching up to 6% of your pre-tax salary. If you make $50,000/year and contribute 6% ($3,000), your employer would put an additional $3,000 into your retirement account. Or, using your extra $1,200 from the example above, your employer would contribute an additional $1,200. After 40 years of growth, your $1,200 contribution puts you ahead by an additional $26,000—without spending a dime.