There are differing opinions on whether or not you should pay off student loans as quickly as possible, start savings for your future or do both. For graduating students trying to make sense of the financial situation they find themselves in can be difficult. This article goes over each of the 3 options graduating students face…
- Pay off student loans as fast as possible
- Start and build a savings account before paying off student loans
- Pay off student loans fast but set up your savings account & automate small monthly savings deposits
Option 1 – Pay Off Student Loans As Fast As Possible – No Savings
In this school of thought, debt of any kind is bad and should be avoided at all costs. Dave Ramsey is a big proponent of this school of thought who believes paying off debt of any kind should be the priority for people trying to become financially independent.
1. You don’t know the future– The future is unknown and you don’t know what it will bring. That large student loan debt (a.k.a. student mortgage) limits you. Examples:
- I’ve met female lawyers and docs who want to pause or quit their practice to start a family, but they can’t due to their $100,000+ student loan debt.
- You are counting on the fact that you’ll be able to work, but the possibility for disability is a reality (another reason for disability insurance).
- If you’re single and thinking of getting married, why bring debt into the relationship? Debt just isn’t sexy and might actually turn off a potential financially responsible spouse.
- So many other possible future unknowns: death, sickness, divorce, change of professions…etc.
2. You’ll have more choices- Being debt free gives you choices. Want to transition to a lower paying job that you actually like? Do it! You want to live off one income? Go ahead!
Our family was able to do just this. My wife was able to quit her day job and stay home with our son since we paid off the remainder of my student loan. If we still had debt, this choice might not have been possible.
3. Opportunity cost– By paying principal and interest, the opportunity cost to grow your net income is gone.
Just think what you could do with your student loan payment? What if you paid off your your student loan early and had an extra $250 to apply towards savings or debt?
That is $3,000 a year that could be working for you earning interest! Action – Figure how much you are missing out per year due to your student loan debt.
4. Freedom– Being debt free except for your mortgage gives you a feeling of freedom and relieves stress. Being able to rest at night, knowing that you don’t owe anyone is a great feeling–I dare say being debt free is addictive.
Option 2 – Build an Emergency Fund or Invest Before Paying Off Student Loans
Because student loans often have better interest rates than other debt it is argued that it is better to build a savings account while only paying the minimum on your student loan.
- The interest rates on student loans are usually fairly low. Because interest rates are largely dictated by the Federal Reserve vs. the free market, interest rates are currently artificially low. True inflation is likely much higher than the stated amount (think 6-8% vs. the official percentages that are quoted by the government) because it takes a while for inflation to spread throughout the economy. Assuming your student loans have an interest rate that is less than 8%, you really aren’t losing much by only paying the minimum.
- Build an emergency fund and build investments instead. Instead of paying off your loans early, use the additional money to build up an emergency fund or start stashing away money in your retirement accounts. As I already stated, the interest rates usually are pretty favorable on student loans so you aren’t losing as much as you think on the interest. Use your additional cash to build a safety buffer in the form of an emergency fund or get some exposure to the market in the form of investments.
If you are interested in potentially leveraging your student loans and investing the money David Weliver (@moneyunder30) from MoneyUnder30.com wrote a great post on how to calculate what your break even return needs to be on your investment instead of paying off your loans…
Option 3 – Pay Off Loans Fast But Still Contribute Small Amounts to Savings
Option 3 is that you should pay off your student loans as fast as possible but still take the time to set up your savings accounts and systems to be able to contribute monthly automatically.
The best answer here, and probably the most boring, is to work on all things at the same time. Start paying off a little debt while also saving up and living your life as stress-free as possible. That latter part being the most important here (although easier said than done). Yes it sucks being in thousands of dollars of debt, but we also can’t let it ruin our day to day lives. So I think it’s first worth figuring out how much money you think you’d need in savings to feel comfy right now, and then at the same time how much you can put toward paying off your loans every month while still living normally. Unfortunately there’s no magical %’s here that fits everyone. (Which sucks, I know)
My Reason For Recommending Option 3 – The benefit of setting up a system and getting into the practice of automating your savings is worth more than a potential interest difference between savings and debt repayment. The beauty of option 3 is that when you have paid off your student loan you already have the systems in place to transfer the monthly debt repayment into retirement savings.