Should You Invest Or Pay Off Student Loans First?

Death_to_stock_photography_weekend_work (8 of 10)

One of the most frequent questions I hear from younger investors is whether they should hold off on investing until they pay off their student loans. College tuition has been growing at a rate much higher than inflation for several decades, and for many students, these costs are financed. It’s not uncommon for a student to graduate with six-figures in debt today.

For many, they view their college loans as the monkey on their back and want nothing more that to get rid of this debt as soon as possible. This intense dislike of debt is probably a good thing, especially if it encourages frugal decision making and a focus on financial responsibility. With retirement being 40 years away, investing doesn’t seem to offer the same immediate benefit as plowing as much cash as possible into eliminating student loans.

The problem with waiting to invest is that you miss out on the benefits of compounding. Let’s say Eager Eddie saves $5,000 a year starting at age 30. Earning 8%, Eddie will have $861,584 in his retirement account at age 65. Waiting Walter delays until age 40 to get started, but then invests double of what Eddie saved, $10,000 a year. Believe it or not, at age 65, Walter will still have less than Eddie, only $731,059. Waiting those ten years cost Walter $130,000, even though he contributed twice as much per year once he got started. When it comes to retirement saving, there truly is no making up for lost time.

By contributing to your retirement plan at work, you may be eligible for a company match. But even if there is not a company match, being able to make a tax deductible contribution will provide an immediate benefit of 25%, 28% or more, depending on your tax bracket.

Some will point out that with interest rates of 6% or higher, that there is no guarantee that their investment return will exceed the rate they would save on paying down their loan. Wouldn’t it be better to take the “sure thing” of saving 6% rather than the venturing into the unknowns of the investment world? The problem with this line of thinking is that your debt will decrease each year, so a 6% interest rate will cost fewer and fewer dollars each year. However, as your investment portfolio grows through contributions and compounding, a 6% return will equate to larger dollar growth rates. In other words, a 6% return on a $500,000 portfolio is ten times more than a 6% cost on a $50,000 loan.

My advice is don’t wait to get started investing. It’s not a choice of either-or; you have to find a way to do both investing and paying off your student loans.

A couple of additional considerations:

  • If you ever needed money, you could access your investments (with possible penalties and taxes for retirement accounts), but if you put extra towards your loans, you cannot access that money later.
  • You may be able to deduct student loan interest paid, up to $2,500 per year. This is subject to a phaseout if your income exceeds $65,000 (single) or $130,000 (married). See IRS Publication 970 for details.
  • If you have Federal loans, make sure your read my article on Four Student Loan Forgiveness Programs, which also explains Income Based Repayment plans.

Four Student Loan Forgiveness Programs

file7931249324351

The size of student loans has grown tremendously in recent years. Many college graduates are finishing school with $100,000 or more in debt, especially those who pursue graduate degrees. It is becoming a substantial problem, one which is impacting a whole generation’s ability to become wealthy. Perhaps for the first time in American history, our young people face a tougher road to prosperity than their parents did.

With higher unemployment today for new graduates, and stagnant entry-level wages in many fields, it can be a significant burden to repay student loans, let alone save money for a 401(k), get a home mortgage, or do any of the financial planning steps I typically write about. For those who are struggling with their student debt, there are a number of student loan forgiveness and repayment programs which can help.

Student loan strategies are becoming an important part of financial planning, given the weight of this debt on young people. At Good Life Wealth Management, we’re prepared to help recent college graduates navigate these issues, as well as to work with parents who want to ensure their children get started on a path to prosperity. If your financial advisor doesn’t know about these programs, you need a new financial advisor! Here is an introduction to four loan forgiveness and repayment programs available today.

1) Public Service Loan Forgiveness (PSLF) Program. This program will forgive 100% of your eligible loans after you make 120 payments (i.e. 10 years of monthly payments), while employed full-time in a public service job. To qualify, you should use one of: the Federal Income-Based Repayment (IBR) Plan, the Pay as You Earn Repayment Plan, or the Income-Contingent Repayment (ICR) Plan.

Only loans received through the William D. Ford Federal Direct Loan Program eligible for the PSLF. However, if you have Perkins or FFEL loans, you may consolidate them into a Direct Consolidation Loan and then they will become eligible for the PSLF.

Public service jobs include those with a federal, state, or local government agency or public school or library. Additionally, a full-time job with any 501(c)(3) non-profit organization is also considered a public service job, regardless of what the organization does. For my musician colleagues, please note that a full-time position with a symphony orchestra, opera company, private university, or music school, would all qualify for the PSLF, provided the employer is a 501(c)(3). Likewise for employees who work full-time for an animal shelter or rescue group.

Payments made after October 1, 2007 may qualify for the PSLF. For further details on the program as well as instructions on how to verify and record your eligibility, please visit the Federal Student Aid Website.

2) Maximum repayment periods on Federal income-driven plans. If you participate in one of the three Federal income-driven plans, there is a maximum amount of time under these loans. If you still have a balance remaining at the end of that term, your balance will be forgiven. Please be aware that the amount of the loan forgiveness will be considered taxable income in that year and reported to the IRS.

Here are the maximum repayment periods:
IBR for new borrowers after July 1, 2014: 20 years
IBR for borrowers before July 1, 2014: 25 years
Pay as You Earn Plan: 20 years
ICR Plan: 25 years

Individuals who are making small payments under an income-driven plan sometimes find that their balances are actually growing rather than shrinking. While I’m not sure it’s a good idea to minimize your income for 20-25 years to qualify for this program, you may take some solace in knowing that your debt will eventually be forgiven as long as you continue to make on-time payments.

For details, visit this page on the student aid website.

3) Loan Forgiveness for Teachers. There are several programs offered by both Federal and State governments to offer loan forgiveness to public school teachers. Some of these programs are used to attract teachers in specific high-demand subjects, or to low-performing schools which struggle to attract qualified candidates. In addition to the PSLF described above in #1, teachers in Texas may be eligible for the Federal Teacher Loan Forgiveness Program, or the TEACH for Texas Loan Repayment Assistance Program, Details available on the Texas Education Agency Website.

4) Military College Loan Repayment Program (CLRP). Several branches of the military offer a loan repayment program to new enlisted personnel (not officers). The Army and Navy will repay up to $65,000 in student loan principal (but not interest), paying one-third at the end of your first three years of enlistment.

Payments are made directly to the lender, but are considered taxable income to the individual. For general information on the program, here is a good article on the CLRP. For details on the Army program, click here.

Using a loan forgiveness program could save you $50,000 or more, and allow you to move forward with your other financial goals, such as building an emergency fund, saving for retirement, or buying a home. Since each program has very specific requirements, it’s best to plan ahead and know which program you may be eligible for, and make sure you follow the rules carefully.

Several of these programs apply only to Federal Student loans. Be careful about consolidating your Federal loans into a private bank loan as this could cause you to lose your eligibility for a forgiveness or repayment program.

Student Loan Strategies: Maximizing Net Worth

IMG_9606[1]

For today’s young professionals, student loans have grown to become a significant financial obstacle. A common question is if it makes sense to pay off these loans early.

First, before considering making additional payments, I’d counsel investors to:
1) have paid off any credit card balances;
2) establish an emergency fund of at least 6 months reserves, and 12 months if their income is unknown or employment is in any way tentative; and
3) save up for a house down payment, if home ownership is a goal.

Having the cash available to pay off a loan is terrific, but I caution people to not forgo their retirement savings in lieu of their student loans.  I know that for many recent graduates it seems appealing to get out from under those loans as quickly as possible, so they think they should wait on contributing to their 401(k) and put as much as possible towards the loans.  When you look at the effects of compounding, however, the money you invest in your 20’s and 30’s into your retirement accounts is much more valuable than the same dollars invested in your 40’s and 50’s.  Often times your net worth will be higher by starting to invest earlier and taking your time with the loan repayment.  And of course, you can test this projection with most financial planning software programs or a spreadsheet.

Another factor to consider on the decision to repay is the tax deduction.  For 2014, you can deduct up to $2,500 in student loan interest from your federal tax return.  This deduction is limited, however, based on your modified adjusted gross income (MAGI).

Single taxpayer: full deduction below $65,000 MAGI, phaseout $65,000 – $80,000
Married filing jointly: full deduction below $130,000 MAGI, phaseout $130,000 – $160,000

I would note that student loan rates are variable and have crept up in the past couple of years. Additionally, as your career progresses and income increases, many families lose their eligibility to take advantage of this tax deduction. I point this out because another important question is: Which is better to pre-pay, student loans or your home mortgage?  The mortgage interest deduction does not have an income limit and is not capped at $2,500.  Also, most mortgages are fixed, not variable.  That’s why I suggest most borrowers make extra payments towards student loans rather than their home mortgage.

For those who can receive the student loan interest tax deduction, it lowers your cost of borrowing, so I would consider the after-tax cost of borrowing when deciding if early loan repayment makes sense.  Most borrowers I counsel have multiple loans at various interest rates, so it is often best to send extra payments towards the student loan with the highest interest rate and make only the minimum payments on the other loans.  Over time, we will pay off the highest rate loan first.  Then that monthly payment can be applied towards other loans.  Additionally, paying off one loan first will reduce your total monthly minimum payments, which is highly valuable should you have any sort of temporary setback like a job loss.

The earlier you can make extra payments, the better.  If your interest rate is 5%, paying an extra $1,000 today will mean that you are saving $50 in interest in every year going forward.  Early principal payments will shorten the length of the loan more dramatically than extra payments made in future years.  If you scrimp a bit now and make extra payments, you will reduce your total interest payments over the life of the loan.

Be careful about consolidating loans. Most people consolidate to lower their monthly payment amount, but inadvertently add years to their loans and thousands in interest payments. Additionally, if you are consolidating Federal loans, such as Stafford Loans, into private loans, you will be giving up access to Federal loans benefits such as forbearance, income-based payments, or loan forgiveness. Before consolidating, make sure you are not going to lose any pre-paid interest if you are ahead on your payment schedule.

Many people think a financial plan deals only with the Asset side of your balance sheet, but some of the most important choices are about how to manage your Liabilities. Student loans are an investment in yourself, so make sure your subsequent cash flow decisions are helping to maximize your net worth in the long run.