The following is a guest article by Jon M. Luskin, a fee-only CERTIFIED FINANCIAL PLANNERTM (CFP®) at Define Financial.
If you’re spending less money than you make, give yourself a pat on the back for being frugal! But, how are you going to handle that extra cash: pay off your student loan debt, or invest?
Why would anyone with a student loan balance invest in the stock market? Because you’re hoping that the investment return will be greater than the interest rate on your student loan.
Investment Return > Student Loan Interest Rate
Notice that the keyword is “hope.” Will your investment return actually be greater than your student loan interest rate? Maybe. It depends. On what? A few things. Read on to find out!
#1: What’s the interest rate on your student loan?
If the interest rate on your student loan is 2%, you’ve got good odds that your investment return can beat it. Why? Because historically the United States stock market has averaged an investment return of roughly 10%. (10% is the return you got for investing in all U.S. stocks, and doesn’t apply to less successful strategies, such as dividend investing.)
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CRSP 1-10 Annual Return, sourced Dimensional Fund Advisors Returns Web
Will the U.S. stock market average 10% going forward? Maybe. But even if the stock market averages half of its historical average (i.e. 5%), that 5% is still more than twice a student loan interest rate of 2%. You can even buy a long-term United States government bond that (if held to maturity) will guarantee you a higher investment return than 2%.
But what if your student loan interest rate is 6%, 7% or 8%? Will your investments generate more than an 8% return? While it is certainly possible, historical evidence suggests that it is much less likely.
So, if you are considering investing while you still have student debt, first look at the interest rate on your loan. If the interest rate on your student loan is rather high, you should reconsider your decision to invest.
#2: What’s your risk tolerance?
Recall that United States stocks have historically produced an investment return of roughly 10%. The keyword in the sentence is stocks. And stocks are volatile. Stocks move up and down in value in an instant, and on a whim. Because stocks can be very risky investments, many investors choose to pair their stocks with bonds, creating a diversified and less risky portfolio.
But, because bonds are not as risky, bonds offer a much smaller investment return (compared to stocks). When you invest in bonds, you’re half as likely (historically) to achieve that historical 10% investment return.
| Chance of Achieving Annual Investment Return Greater than 10%, 1926-2015 | |
| Stocks | 56% |
| Bonds | 28% |
CRSP 1-10 Annual Return & Long Government Bond Return (data from Ibbotson & Morningstar), sourced Dimensional Fund Advisors Returns Web
So, if you’re not going “all in” with stocks – and are instead choosing to water-down the potential investment return of your portfolio with bonds because you can’t stomach the risk – then maybe it doesn’t make sense for you to invest while you still have a student loan balance. Remember, to be successful at investing when you have debt, you need to earn an investment return greater than your student loan interest rate.
Investment Return > Student Loan Interest Rate
A portfolio holding bonds may not get you the investment return you need to beat the interest rate on your student loan balance.
#3: What’s your after-tax rate?
While it may be relatively easy to earn an investment return than the 2% on your student loan, it’s even easier to beat 1.5%. Why would your student loan interest rate of 2% suddenly drop to 1.5%? Taxes.
You’re probably aware that you can write off a portion of your student loan interest for tax purposes. Of course, there are limits and restrictions to the write-off. But, if you do qualify for the tax deduction, your after-tax student loan rate will be less than the rate you pay before taxes.
2% student loan interest rate + 25% tax bracket = 1.5% after-tax student loan interest rate
But, it works both ways! So, if you’re investing in a taxable account (i.e. not an IRA, 401(k) or similar retirement plan), then your investment return also gets reduced because of taxes.
Let’s use an example to see how this works:
Phillip has an 8% interest rate on his student loan and he’s already maxed out the amount of interest that he can write off. He’s managed to earn a 9% investment return in his taxable investment account.
| Investment Return | 9% |
| Student Loan Interest Rate | 8% |
He’s made it, right? A 9% investment return is greater than an 8% student loan interest rate, right? Nope. Because you need to consider taxes.
After accounting for taxes, the 9% investment return is now roughly 7%. Given that, it would have made more sense for Phillip to pay off his student loan balance than invest.
9% investment return – taxes = ~7% investment return
But what if you’re using a retirement account where special tax treatment shields your investment return from the drag of taxes? When you use an IRA, 401(k), or similar type of retirement account to invest, you don’t have to adjust your investment return for taxes.
So, if your student loan interest rate is 8% and your investment return in your IRA account is 9%, congratulations are in order; you’ve successfully outperformed your student debt interest rate!
9% investment return in a retirement account = 9% investment return
Given all this discussion about taxes, you may be tempted to include the tax deduction for your IRA or 401(k) contribution in the calculation. (You get a tax deduction when you put money into your traditional IRA or 401(k) or 403(b) or 457(b) account.) But, you cannot count the tax deduction towards beating your student loan debt because you must eventually pay taxes when you take money out of these special retirement accounts.
#4: Are You Getting an Employer Match?
If you’re investing using your employer’s retirement plan (and that employer is matching your contributions), you’re getting an amazing deal. Why? Because taking advantage of an employer match gives you an instant (and guaranteed) boost to your investment return.
Let’s use a 25% match to illustrate the value of an employer match. Recall that investing in stocks has historically averaged a 10% return per year. So, were you to invest, you might expect a 10% return after one year. And that’s not bad; that 10% would easily outperform the interest rate on your student debt loan balance.
Now think about what taking advantage of your employer’s match on your retirement plan (i.e. your 401(k) etc.) does for your investment return: you get an additional 25% investment return in the first year!
10% investment return + 25% employer match = 35% more money!
But, averages are just that. They are not guaranteed. So, what if your investment account loses 10% in the first year? (Over the last 90 years, you had a 25% chance of losing 10%!) Don’t worry about that 10% loss, because you’re still way ahead of your student debt interest rate – all thanks to your employer’s match.
-10% investment loss + 25% employer match = 15% more money!
So, if you’re grappling with the decision to invest or pay off your student loan balance – and your employer is offering you free money to invest in your company retirement plan – take the free money! Contribute the amount that will get you the full employer match.
In Conclusion
Know that investing while maintaining a student loan balance is a risky proposition. By paying off your student loan balance, you’re getting a guaranteed investment return equal to your student interest rate.
Paying Off 8% Student Loan Debt = Guaranteed 8% Investment Return
Depending upon your student loan interest, this may (or may not) be a good idea. Because when it comes to investing, the amount of money you make (i.e. your investment return) is rarely guaranteed.
Investing in the Stock Market ≠ Guaranteed Investment Return
If you understand the risks, consider the ideal circumstances for investing while carrying a student loan debt balance:
- Have a low interest rate on your student loan
This means success is measured by jumping a lower hurdle. It’ll be easier for your investment return to beat a lower interest rate than a higher rate.
- Be able to write off your student loan interest payment
Having an even lower after-tax student loan interest rate increases the chance that you’ll be able to beat that after-tax rate when investing.
- Invest using a tax-advantaged account
If you can shield your investment return from taxes by using an IRA, 401(k) or other retirement account, you’ll have better odds that your investment return will be higher than your already low, after-tax student loan interest rate.
- Take advantage of your employer match
If your employer offers just a 10% match (i.e. 10 cents for every dollar you put in), the investment return on the match itself is likely higher than your student loan interest rate. Jump on it!
Consider All Your Goals
While paying off debt is always great (and satisfying), it may be just one of your financial goals. You may have other goals as diverse as:
- Saving for a home purchase
- Creating an emergency fund
- Launching a business
So, while investing and paying off debt are important – don’t look at these goals in isolation. Consider using the money you have to get closer to all your goals – or the goals that are most important to you.
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