Compound interest is one of the most exciting, powerful and remarkable forces in finance.
Given enough time, a modest amount of money can grow into a bundle of wealth.
It’s no surprise that financially savvy people preach investing early in your career, even if it’s a small amount. But with tuition and fees averaging about $40,000 per year for private colleges, students these days often enter the workforce with considerable student loan debt.
How do you split up your income early in your career? And what factors should you consider when deciding to invest or pay off debt?
That’s what a listener of the Clark Howard Podcast recently asked.
Should I Invest or Pay Off My Debt?
Thinking about how to allocate your money can be overwhelming, even if you know your goals.
A listener posed an interesting question on that topic on the Nov. 30 podcast episode.
Madison in Ohio wrote: “I recently graduated from physical therapy school and have student loan debt worth about one year of my salary. I was also educated by my parents to invest and start my retirement as soon as possible. I was wondering if I should focus on paying my loans off or invest part of my salary. What would be a happy medium so I could do both?”
First things first, Clark says: Make sure you’re making the minimum student loan payments no matter what. Don’t do anything that’s going to mess up your credit.
However, the first real financial move is to contribute enough to your company 401(k) plan to capture all of the 401(k) company match. If that’s an option for you, Clark says you should take the free money.
“The place you’ve gone to work, if they have any match of the retirement funds, that is the higher priority. Put money in that before you worry so much about anything other than just servicing the student loan debt. That has to come first.”
Why Your Interest Rate and Loan Type Matter
Beyond paying the student loan minimums and contributing enough to your 401(k) plan to secure the company match, it’s time to examine your student loan interest rates.
Hopefully, the interest rate is low and locked for the remainder of your payment schedule, Clark says.
“We went through several years that student loan interest rates from federal sources were fixed at very low rates,” Clark says. “For those, you only pay the minimums required.”
If your student loan rate is less than, say, 6%, you’ll probably be able to earn more money by investing for retirement than you’d save by paying off your loans early.
That’s not the case if any of your loans include variable interest rates. Prioritize paying those off ahead of investing, Clark says. Especially with the Federal Reserve raising interest rates every time it meets right now.
Finally, Clark told the listener, who’s a physical therapist, to look into whether she’ll qualify for public service work loan forgiveness. If she qualifies, loans will be forgiven after 120 months (12 years). He advised her to pay the minimums on those loans if that’s the case.
“You don’t look at this decision as an either/or. It is a series of decision trees. With the first being, the retirement plan at work is ultra important if there’s a match,” Clark says.
“As you can see, this is not one that has, ‘OK, automatically do this. Automatically do that.’ It really is a series of questions you’ve got to answer. One of the primary things is [that] floating rate loans are really bad. Pay on those. Fixed rate loans that are low, pay the minimums on those. Loans that are federally guaranteed, that are eligible … for the 10-year federal loan forgiveness, those you pay only the minimums on.”
Final Thoughts
If you’re deciding whether to pay off student loans or invest for retirement, Clark’s advice on your first step is clear: Make sure you make the minimum payments on any debt that you’re carrying.
Beyond that, take advantage of any 401(k) company match before doing anything else. Then check out your interest rates. Are they fixed or variable? Will you be eligible for any student loan forgiveness? What are the actual rates?
The answers to those questions can help you decide to invest or pay off debt.
