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Question: I’m trying to figure out what to do about paying off my student loans and investing in retirement. Should I pay off debt or invest in my IRA?
I just graduated college in May and began a full-time job in October making $36,000. I also do freelance work and receive anywhere from $500 to $1000 a month from that. I’m still living at home, and don’t have to pay rent or groceries, which really helps.
Currently, I have just over $18,800 in student loans at an average interest rate of 4.45 percent. I just started paying against them last month. And I have also opened a Roth IRA with just under $2,000 in there. My plan currently is to contribute $500 a month to my IRA. That way, I can max it out and pay $700 a month to my student loans.
My question is: Should I leave my IRA as it is and put that $500 a month toward my student loans in order to possibly get them done within a year?
The stock market has done nothing but fall since I opened my account. And I’ve read that could continue this year. But I’ve also read that it’s good to just keep contributing to an IRA when your debt isn’t high interest, in order to reap the rewards of compounding interest. I plan to move out of my parents’ house after a year. So, I think not having any debt would help with that a lot.
Would I be better off to stick with the course I’m on and knock out the debt in 2.5 years? Would not investing in my Roth IRA for a year or so make me miss out on potential compound interest, even if the market will likely go down stay the same? Or would it be too negligible to matter?
– Michael in Kentucky
Michael, as with most questions in personal finance, the answer to yours is: It depends. The right path forward hinges on whether we’re focusing on the “finance” part of personal finance or the “personal” part…
Financially, it seems like investing could earn you more money in the long run than paying off your loans early. Your student debt has a relatively low-interest rate of 4.45 percent. So, it’s not costing you a huge amount in interest over time. Depending on your credit, you could even consider refinancing for lower rates.
Your return from the IRA can, of course, vary depending on what sort of assets (stocks, bonds, etc.) you invest in and how the market performs. As personal finance expert Dave Ramsey notes, it’s not unreasonable to see the S&P 500 benchmark stock index earn investors in those shares 12 percent or more per year. In such a scenario, the gains from investing could outpace the interest you’re paying on your student loans.
Since you’re starting young, your money will have time to grow. And you’ll be able to weather any temporary dips in the market. The effects of compound interest grow more powerful over time. Putting that extra $500 into your IRA could result in greater savings in the future than waiting until you’re debt-free.
You can use a student loan payoff versus invest calculator to see exactly how much money you could make by investing your extra $500 per month instead of throwing it at your student loans.
Of course, a return of 12 percent isn’t guaranteed, and no one can predict what will happen in the future. We can only base our predictions off past economic behavior to guess what can occur in years to come.
The financial answer to your question seems to come out in favor of investing. However, the “personal” answer might lead you to a different conclusion. If you’d rather be debt-free and have a low tolerance for investment risk, you should pay the loans back first.
By making extra payments, you’ll get out of debt faster and save money on interest in the short term. Although your savings might not match what you could earn over the long run through investing, you’ll experience their effects much quicker.
By saying goodbye to your student loan payments years early, you’ll also have more of your monthly income to keep for yourself. This could be helpful if you’re looking to rent an apartment, buy a car or make another big purchase for yourself.
All in all, you’ll probably reap the rewards of paying off your student loans earlier than you would enjoy the fruits of investing. But if you’re playing the long game, putting extra money into your IRA will likely earn you the most money overall — you’ll just have to wait a few decades to enjoy it.
I would add that paying off student loans and saving for retirement aren’t your only financial priorities. It’s also important to put money aside as an emergency fund. You’ll be prepared for an unexpected expense if you have some liquid savings.
Most experts recommend putting aside between three and six months’ worth of living expenses in your emergency fund as a financial cushion. Once you have your savings set aside, then you can use the leftover monthly income to invest or prepay your loans.
In the end, the decision to pay off debt early versus invest comes down to two main factors: what the numbers say, and what your personal feelings are about debt. Investing could earn you more overall, but that doesn’t mean paying off your student loans faster is the wrong choice.
If getting out from under the shadow of debt is your priority, feel free to throw that extra $500 at your student loans until they disappear.
Reflect on your personal short- and long-term goals, and let those goals help you strike the right balance between paying off student debt and investing in your IRA.
Andrew Pentis is a student loan expert and a writer for Student Loan Hero.
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