Paying Off Student Loans vs. Investing: Which Should You Prioritize? (2024)

Investing is an important part of building wealth for the future, but if you have student loans, you may feel like you need to get them paid off before you begin investing. Neither option is inherently better than the other, as the "right" one to prioritize will depend on your goals and how comfortable you are having debt. Before you decide between using extra cash to either pay down student loans or invest, you'll want to ensure you fully understand your financial situation.

Paying Off Student Loans vs. Investing: An Overview

Paying off student loans early can bring peace of mind, in addition to reducing the amount of interest you pay over time. On the other hand, investing works best when you start early and be consistent. The potential returns might outweigh what you're paying in interest.

Factors to Consider

Personal Financial Goals

First, think about your financial goals and priorities. Determine whether you want to be debt-free faster or build wealth for the future. Carefully think about which goal makes the most sense for your situation. Perhaps you need to get out of debt to qualify for a mortgage before you save for retirement. Or maybe you're comfortable carrying some debt and want to build an emergency fund to prepare for unexpected expenses first.

In some cases, student loan debt can keep you from reaching other goals. By paying it off, you might feel more freedom to make progress in other areas of your life. On the other hand, you might want to build wealth earlier by putting your extra money to work through investing.

Interest Rates

Interest is the money you pay to borrow money. Student loan interest rates vary, so some of your loans might have higher rates than others. Even if you consolidate your loans to one interest rate, you're still paying interest.

Additionally, interest accrued during your time in school or a deferment or forbearance period will likely be added to your outstanding loan balance. As a result, you're now paying interest on that accrued interest. The faster you pay off your loans, the more money you save in the long run.

Let's say you consolidate your federal loans. The formula for determining your interest rate for a loan consolidation considers your balances and statutory interest rates. To calculate your new consolidation loan balance and interest rate, total the balances and average the interest rates of the loans you're consolidating, rounded up to the nearest one-eighth of 1%.

Say you have the following undergraduate unsubsidized loans:

• $5,500 at 5.05%
• $6,500 at 4.53%
• $7,500 at 2.75%
• $7,500 at 3.73%

In this case, a consolidation loan would be for $27,000 and have an interest rate of 4%.

If you're concerned about compounding interest and have an interest rate that's high relative to potential returns, repaying student loans might make sense.

Potential Returns on Investments

Paying off debt is often considered a "guaranteed return" based on your interest rate. However, what if your potential investment returns are higher than the interest rate on your student loans?

In the example above, you're paying 4% on your student loans. However, the long-term average is about 10%, more than twice the rate of some student loans. In that case, you might be better off putting more of your discretionary income toward investing since your returns could be much higher than what you'd be paying in interest.

Keep in mind that the stock market can be risky and isn't guaranteed to provide returns each year.

Risk Tolerance and Time Horizon

Before investing, you should know your risk tolerance and time horizon, or how soon you may need access to the invested funds.

For example, if you need access to your money in the short term and the market is down when you sell your investments, you may suffer a loss. However, if you don't need the money and have a longer time horizon, you can afford to wait for the market to bounce back before selling your investments.

How soon you may need access to your money can help you determine the level of risk you can tolerate and, ultimately, the type of investment, such as stocks, bonds, or certificates of deposit (CDs).

Type of Student Loan

Compared to federal loans, private student loans typically have different terms and access to fewer benefits and programs. In that case, you might decide to tackle your private loans first. Then, you may want to address your federal student loans or choose to invest first.

If you're not eligible for federal student loan repayment programs, you may also be able to refinance all of your private and federal loans together into one private loan with the same term but at a lower rate. Then, you can reduce your debt faster without paying as much.

Tax Deductions

You can potentially deduct up to $2,500 of your student loan interest when you prepare your taxes. This can lower your taxable income and reduce how much you owe. In some cases, depending on your rate, the tax deduction might offset a portion of the interest you pay.

A quick way to estimate your tax deduction is to multiply the dollar amount of your total interest payments by your tax bracket. For example, if you pay $1,500 in student loan interest during the year and you're in the 22% tax bracket, your deduction is worth $330. That's not enough to fully negate your interest, but you might decide it's enough to adjust how you allocate money for paying off student loans versus investing.

Forgiveness Programs

Finally, consider whether you're eligible for federal forgiveness programs. Private student loans aren't eligible for forgiveness, but federal loans might be.

• If you're on an income-driven repayment (IDR) plan for 20 or 25 years, your balance might be forgiven.
• The Saving on a Valuable Education (SAVE) plan doesn't accrue interest if you make your full payment each month, and it isn't enough to cover the interest that would've accrued.
• If you’re employed by a government or not-for-profit organization, you might be eligible for Public Service Loan Forgiveness (PSLF) after making 120 qualifying payments.
• Other loan programs, such as the Teacher Loan Forgiveness Program and state programs aimed at healthcare providers, are also possible options.

If you can get a lower monthly payment that frees up more money to invest, and you know you'll get some level of student loan forgiveness, it'll be easier to make building wealth a priority.

Paying Off Student Loans Early

You should prioritize paying off student loans early if...

• You have high-interest student loans, especially private loans
• Having debt causes emotional stress, and being debt-free would offer peace of mind
• You don't qualify for any IDR plans or student loan forgiveness programs
• A high student loan balance is keeping you from reaching other goals
• Your employer offers student loan repayment assistance

Pros and Cons of Paying Off Your Student Loans First

How to Pay Down Student Loan Debt Faster

You can take several steps to pay down your student loan debt more quickly. These include:

• Making bi-weekly payments instead of monthly payments to get an "extra" monthly payment each year
• Designating extra payments to go toward the principal, instead of pre-paying fees and interest
• Cutting back on unnecessary costs and putting the savings toward paying down student debt
• Looking for ways to earn extra money to put toward your student loan payment
• Putting windfalls, such as tax refunds, bonuses, or gifts, toward your loan repayments

Investing Toward Other Goals

You might prioritize investing if...

• Your employer offers to match the amount you invest with a company 401(k) plan
• Your student loan interest rate is lower than your forecasted long-term returns from investing
• You can maximize tax deductions from both retirement contributions and student loan interest
• You expect to be eligible for student loan forgiveness and qualify for an IDR plan
  

Pros and Cons of Investing

The Bottom Line

Whether you're better off paying down student debt or investing will depend on your situation, financial goals, and how you feel about debt. Additionally, it's important to realize that it's not an either/or situation. You can always invest a portion of your discretionary income while still tackling your student loan debt.