How to Balance Paying Off Student Loans and Saving for Retirement
If you recently graduated from college and joined the workforce, you might be wondering: should I pay off my student loans before saving for retirement? Many recent college graduates put off saving anything toward their retirement and try to pay as much as they can to get rid of their student loans as fast as possible. But people who have a long time until retirement benefit the most from the long-term growth of their investments and the power of compound interest. So how do you create a balance between shrinking your debt and growing your retirement savings?
The first thing to consider is whether your employer matches your savings if you contribute to a 401(k) plan. Many employers will match their employees’ contributions, up to a point. The most common matching contribution is up to 6 percent of the employee’s salary. But if you choose not to contribute to the 401(k), you do not receive the employer match, which means you miss out on extra income.
Quick reminder: If you are thinking about contributing toward a 401(k), be sure that you take a look at your monthly budget before signing up. Paying bills and saving up an emergency fund are highest-priority. Carrying a balance on a high-interest credit card can erase the gains you make from investing toward retirement, so be sure to pay those off first. And even if you decide to prioritize retirement savings, make sure you always make the minimum payments on any loans to avoid damaging your credit.
Okay, so if you have your regular savings set aside and your bills are paid, how do you choose whether to pay extra toward student loan debt or save more for retirement? First, if you are lucky enough to work for an employer who matches your 401(k) contributions, try to contribute enough to receive all of the available match. If you do that, you get an immediate return on your investment, and take advantage of a key benefit provided by your employer.
If you are already saving enough toward retirement each month to receive all of your employers matching contribution to your 401(k), and you still have a little bit left over, what should you do with the extra income? Unfortunately, there is no easy answer to this question, since what you decide to do depends on the interest rate for your student loans, how well you expect investments to do in the years between now and retirement, your tolerance for risk, and your comfort with debt. Analysts disagree about how much investors should expect their retirement savings to grow over the next 40 years, but most think that the long term return on investments will be between 6-8%. A frequently cited rule of thumb is to pay off any debt with interest higher than that 6-8% first, and to prioritizing saving for retirement over paying off loans with lower interest rates.
Consider a simplified example to explain that rule of thumb. If you have an extra $100 in your budget at the end of the month, you could choose to save that toward retirement. If you retire in 40 years, and you get a return on investment of 6%, then the $100 you saved now becomes $1,000. If your investments grow 8% year over year for the next 40 years, then that $100 becomes $2,000! If you paid that same $100 toward a 10% loan with a 25-year term, you will save $1,000 over the life of the loan. If that loan only has 6% interest, however, then you only save $500.
One final note: paying off loans early frees up money in your monthly budget when you no longer have to make the monthly payments. For this reason, you might choose to focus on paying off your loans because it will give you more flexibility and mean that your emergency savings will last longer if you experience a sudden loss of income. It is hard to weigh the long-term benefit of extra savings toward retirement against this flexibility and security. Also, keep in mind that most retirement savings cannot be withdrawn early without paying a penalty, so you will want to be sure to have emergency savings separate from your retirement savings. Finally, the big thing to remember is to always take advantage of your employer’s 401(k) match if you can!
Until next time!
Small Business Coordinator