Should I pay off Student Loans or Invest?

Wondering if you should pay off student loans or invest? Which has the highest expected rate of return? To answer this question, we’ll first have to analyze your student loan interest rate vs. the investing expected return. Keep reading to find out the best decision for you.

Student Loan Interest Rate

In order to make the best decision for you, you need to start by analyzing your student loan interest rate. Please tell me you know what your student loan interest rate is!

Your student loan interest will depend on the type of loan: subsidized vs. unsubsidized, undergrad vs. graduate vs. parent, and possibly other factors.

In just one example, here’s a table that provides interest rates for Direct Subsidized Loans, Direct Unsubsidized Loans, and Direct PLUS Loans according to the Studentaid.gov site:

IF you have something called a Perkins Loan, the interest rate is fixed at 5%,  regardless of the first disbursement date.

You’ll have to pay interest on capitalization, in a similar way to how we collect compound interest on our investments. The studentaid.gov website gives an example of how capitalization on your unpaid interest works:

“For example, on a $10,000 Direct Unsubsidized Loan with a 6.8% interest rate, the amount of interest that accrues per day is $1.86 (find out how interest is calculated). If you are in a deferment for six months and you do not pay off the interest as it accrues, the loan will accrue interest totaling $340. At the end of the deferment, the accrued interest of $340 will be capitalized, and you’ll then be charged interest on the increased outstanding principal balance of $10,340. This will cause the amount of interest that accrues per day to increase to $1.93. Capitalization of the unpaid interest may also increase your monthly payment amount, depending on your repayment plan.”

Basically you’ll be paying interest on top of your interest. Just like how you’ll gain interest on top of your interest when your investments are collecting compound interest.

For some types of loans, you’ll also have to pay a Loan Fee. This loan fee is in addition to your interest and loan principle payments. Here is a chart of the loan fees for direct subsidized loans and direct unsubsidized loans for some loans. Notice how the loan fee is much higher for Direct Plus Loans than for Direct Subsidized Loans and Direct Unsubsidized Loans. 

It appears that the loan fee is a one-time expense that is subtracted from each of your loan dispersements. According to the website:

“The loan fee is deducted proportionately from each loan disbursement you receive while enrolled in school. This means the money you receive will be less than the amount you actually borrow. You’re responsible for repaying the entire amount you borrowed and not just the amount you received.”

My understanding is that if you take out a $100,000 loan and your loan fee is 1.057%, you will eventually have to pay back $101,057 ($100,000 x 101.057%).

What is your overall effective loan interest rate?

Since the loan fee does not compound like capitalization of unpaid interest, it can be disregarded when calculating your effective loan interest rate.

Your effective loan interest rate is equal to the fixed interest rate on your loan.

Investing Expected Return

The second number your need to calculate is your expected return of your investments.

If you plan to invest in an S&P 500 index fund (which is a good choice) your expected rate of return is NOT fixed. It will fluctuate, but if history serves as a good predictor, here are the results of Schwab’s index fund (SWPPX):

Over 5 years it has returned an average annual return of 14.16%.

Over 10 years it has returned an average annual return of 13.57%.

And over 15 years it has returned an average annual return of 9.19%.

Comparing Effective Loan Interest Rate vs. Expected Investing Return

I suggest that you look at your actual loan paperwork and statements to determine the actual loan interest rate you are paying.

Let’s say for example that your loan interest rate is 4%.

On the conservative side, we’ve seen that the S&P 500 index has returned 9.19% over 15 years.

If you want to compare a longer time frame, it has returned an average of 10-11% annually from 1926-2018. Source:  Investopedia

Since the market yield is expected to be much higher than the loan interest rate (10% > 4%), you should invest your money. If you’re gaining 10% at a cost of 4%, you are essentially receiving a 6% net return over the long run.

Your decision should change if your loan interest is significantly higher. For example, if the loan interest rate were 8% or higher, I would definitely recommend paying off the loan before thinking about investing. A 8% guaranteed return (zero volatility), in my opinion, is better than taking a market return of 10% with substantially more risk (in the short term).

If you do decide to invest, you should still pay off the minimum balance on your student loan as to avoid delinquency and/or default.

Favorable Circumstances 

There may be other favorable circumstances in which investing rather than paying off your student loan is a no-brainer.

Covid Relief

I hate to call Covid a favorable circumstance, but it might be when it comes to your loans.

According to studentaid.gov: “To provide relief to student loan borrowers during the COVID-19 emergency, interest is being temporarily set at 0% on federal student loans.”

0% interest!

Furthermore, on Aug. 8, 2020, President Trump directed the Secretary to continue to suspend loan payments, stop collections, and waive interest on ED-held student loans until Dec. 31, 2020. Source: https://studentaid.gov/announcements-events/coronavirus

The government is providing you money without charging you interest.  This means FREE Money! I mean, you’ll have to pay back the principal, but without interest temporarily.

It makes a ton of sense to invest your money in stocks paying 10% a year, rather than paying off a loan charging 0% interest. That is an expected net return of 10% per year (0.8% monthly)!

401K Match

Does your employer offer to match your 401k contributions? This is a good question to find out from your HR or fiscal department if you don’t know the answer.

401k match is a common benefit that many employers offer today. The most common match is 50 cents on the dollar up to 6% of the employee’s pay. Source: Investopedia

Let’s say that your salary is $80,000. That means that if you contribute anything up to 6% of your salary, which in this case is $4800, your employer will match half of your contributions, which in this case is $2400. This is $2400 in free money that your employer will help contribute to your 401k plan. 

This free money should further entice you to invest, at least up to the percentage amount matched by your employer.

Political Debt Relief Possibilities

As of 2019, the US has outstanding nearly $1.6 trillion in student loan debt. The average college graduate leaves school $30,000 of debt. Source: CNBC

Several presidential nominees have made proposals to rid students and their families of some, if not all, of their student debt burden.

In June 2019, Senator Bernie Sanders announced a plan to erase the country’s $1.6 trillion outstanding student loan tab, releasing all 45 million Americans from their student debt, to be paid for with a new tax on Wall Street transactions. Source: CNBC

In July 2019, Sen. Elizabeth Warren introduced a bill where all 45 million Americans with student debt would see at least a portion of their balance greatly reduced, paid for by a 2% annual tax on accumulations of wealth exceeding $50 million, with an additional 1% levy on wealth exceeding $1 billion. Source: CNBC

Although Senator Sanders and Senator Warren failed to receive the presidential nomination, it is very likely that they, in addition to other politicians, will continue to advocate for such policies. 

I’m certainly not advocating for you to take out hundreds of thousands of dollars in student loan debt with the expectation that the government, via taxes, will one day erase it. That may or may not happen. 

But can you imagine paying off $30,000 in debt, only to find out a few years later that your debt would have been wiped out automagically for free?

Reasons to Pay Off Loan Sooner

Managing your Credit Score

Are you looking to purchase a car or a home soon? What does your credit score look like?

Before you’re able to make such a purchase, it is common practice for your lender to look up your credit score. Your credit score is a number that they use to determine your credit-worthiness. The higher your credit score, the more trustworthy the lender will see you as.

Having a gigantic student loan to your name may negatively impact your credit score. A lender might be reluctant to provide you a mortgage if you still owe $150,000 in student loans! Just think about it. Would you lend a stranger hundreds of thousands of dollars, knowing that they owe hundreds of thousands of dollars to someone else? Unless they’re pulling in millions a year, probably not…

If the student loan is hurting your score, and you want to make a big purchase soon, it might make sense to pay off your student loan, rather than invest. Check your credit score every few months and take steps to boost your score (insert link) before applying for another loan or mortgage.

Psychological Freedom

Some people would advise you to just pay off your student loan as quickly as you can to get the burden of the loan off your mind. 

I would tell those people that, although tempting, this is not the best economical choice.

For example, the effective rate of my mortgage is around 4%. I’m in absolutely no rush to pay off my mortgage quickly, knowing that my money will be in a much better place in the stock market earning close to 10%.

The same goes for your student loan debt. Why pay off your student loans at a 4% rate, when your money will grow much quicker in the stock market?

Psychologically freeing? Maybe.

Economically wise? Most likely not. Psychological freedom, ironically, is different from financial freedom.

Putting it All Together

Should you pay off student loans or invest? The financially savvy way to approach this problem is determine where your money will be best spent. 

If the interest rate on your loan is relatively high and your expected investment return rate is relatively low, it would make appropriate sense to pay off your loan. 

On the flip side, if the interest rate on your loan is relatively low and your expected investment return rate is relatively high, it would make appropriate sense to invest your money, while paying off the minimum balance to avoid delinquency or default.

Favorable circumstances to investing are the 0% rate due to COVID relief programs, employer 401K match, and political debt relief possibilities. However, you might want to pay off your student loan debt sooner if it is impacting your credit score which you’d like to improve for taking out a mortgage, car loan, or any other loan.

Take all of these factors into account before making the decision on whether or not you should any pay off your student loans or invest.

Let me know your thoughts below!

Would you pay off student loans or invest? Are there any other factors that would affect your decision?