Deciding whether to invest or pay down your student loan debts with excess cash you may have available isn’t always an easy choice.
With a career planned in the medical field, Edgar Radjabli left school with $265,000 in student loan debt. But instead of paying it off, he saved excess funds he had and used them to purchase a medical practice, the revenue of which he was able to grow by 120% in a few years — essentially putting that money to better use.
On the other hand, Richard Hudnett and his wife focused on paying down large student debts for their advanced degrees first, choosing to knock them off before having their three children so they could focus on saving and investing with the money they once used to pay off the debt.
“It’s often overlooked the mental drag student loan debt creates for individuals and families, and … shouldn’t be overlooked when reviewing all of the available options, such as investment opportunities to earn a higher rate of return,” Hudnett, an assistant director of program development and recruitment at Nova Southeastern University in Orlando, says.
But thankfully, it doesn’t have to be a matter of one or other when it comes to investing versus paying off your student loans, says Chad Chubb, founder of WealthKeel, a Philadelphia-based financial planning firm.
It all depends on your individual situation and whether you’re maximizing opportunities when they arise. Experts offer the following tips:
— Evaluate your student loan interest rate.
— Reduce your tax first.
— Don’t try to “beat” your student loan interest rate in the market.
— Look at non-security investments.
— Discuss your plan with an advisor — and stick to it.
Evaluate Your Student Loan Interest Rate
Generally, one should rank investment opportunities, including accelerating loan repayment, by the “risk-adjusted after-tax interest rate” and focus first on the highest rate opportunity, says Mark Krantrowitz, publisher of SavingforCollege.com.
So because there are no prepayment penalties on student loans, paying off a student loan is the equivalent of earning the interest you would otherwise pay on the prepaid amount of the student loan, he says.
“If the loan is eligible for the student loan interest deduction, the interest rate should be reduced by the borrower’s marginal tax rate,” Krantrowitz says.
Usually, these interest rates are still higher than other low-risk investment options, such as certificates of deposits or money market accounts.
Your federal student loan may have a below-market rate: “If you’ve got a federal student loan from 2005 with an interest rate below 3%, it is worthwhile to keep that loan as long as possible and invest the money, since the investment returns will likely exceed the interest rate on the debt. But, this is quite rare,” Krantrowitz says.
Reduce Your Tax First
Contributing at least up to any match on your employer-funded 401(k) should always be a first priority.
“Any excess savings that will not reduce your current taxes or create a company match should be used to pay down debt,” says Mark Painter, founder of EverGuide Financial Group in Berkeley Heights, New Jersey.
That’s because tax savings and a company match on a retirement plan, which is essentially free money, directly improve your overall rate of return on your money and increase the chance that you earn a higher return than your student loan interest, he says.
Don’t Try to ‘Beat’ Your Student Loan Rate in the Market
The “average” market returns are still pretty close to the weighted average interest rate for most federal student loans, Chubb says, which hover between 5 and 8%, according to the U.S. Department of Education. With loan rates that high, there is not a “safe” play in the market, so you would have to take on “substantial market risk to even attempt this idea,” Chubb says.
Look at Non-Security Investments
Real estate investing is one of the best ways to outpace the debt of your student loans, says Ian Walker of H&I Investment Group in Arlington, Texas.
“Many smart real estate investors can easily achieve a cash on cash return on their investment of 15% or more. This is typically two to three times the debt service of student loans, making it an ideal destination to invest,” he says.
It could start with your own home, Radjabli, managing partner of West Palm Beach-based Apis Capital Management, says, noting that the after-tax cost of owning is less than renting in many areas.
“The lowest rate mortgages require 20% down. In this case, someone with student loans will be better off saving for the down payment, buying the home, and then enjoying their improved cash flow, or at least the building of equity in the home, and can pay off loans later,” he says. It is one of few opportunities to outweigh the benefits of paying down a student loan early.
Discuss Your Plan With an Advisor — and Stick to It
If you have student loans, there is not a generic cookie-cutter model, Chubb says.
“You should have a full plan built, discuss your goals, career path, and then build the best path forward based on your plan,” Chubb says.
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