Figuring out how to maximize financial stability is a priority for many people. You want to make financial decisions that will help you get the most out of the money you earn. If you are like most people, you carry a certain amount of debt. If you are reading this article, that debt might be in the form of student loans.
If you find yourself in the position where you have an income surplus, you will want to weigh the pros and cons of whether to use that surplus to pay off debts or save or invest it.
Which option is best depends on numerous factors, including your long-term financial outlook and current financial stability, the interest rates on your loans and how they compare to interest rates on savings accounts or potential investments, and your feelings about financial risk.
In this article, we will break down all of these factors so that you can make an informed financial decision that is right for you.
First: Achieve Financial Stability
It’s always a good idea to make sure your day-to-day financials are in order before moving money into inaccessible places – such as putting it toward a debt balance or stashing it away in long-term investments.
What does financial stability look like? Consider the following indicators:
- Your income is stable and predictable.
- You can make minimum payments on all debts.
- You can pay your monthly bills and meet all of your basic living expenses.
- You have set aside emergency funds that are easily accessible if something unexpected happens.
Once all of those indicators are met, then the question of whether to pay off debt, save, or invest becomes relevant. While your personal preferences and risk tolerance play a role, the factor that may determine the biggest financial benefit are the relative interest rates.
If the interest rates on your debts are high, then it makes sense to pay more than the minimum payments until that debt is gone before you invest. If you could earn interest on investments at a higher rate than your debt is gaining interest, then it makes more sense to continue to make the minimum debt payments and invest the remainder of your excess funds.
Interest Rates and Debt Repayment
When you pay on any type of debt, there is almost always interest involved. The debt balance, also called the principal, accrues interest, and each time you make a payment, you pay off interest in addition to the principal.
By the time the entire debt is repaid, the total amount you have paid will be more than the initial debt because of interest. The total debt repayment cost depends on:
- The initial principal: The greater the amount borrowed, the greater the amount you will repay.
- The interest rate: Higher interest rates correspond to higher total repayment costs.
- The length of time it takes to repay the debt: If you take longer to repay a loan, it has more time to accrue interest, and the total amount you pay will be greater.
Debts are the most burdensome in a long-term financial sense when they have very high interest rates. This is more relevant than the principal balance to a degree.
Think about it this way: If you had a very high debt balance, but it didn’t accrue interest, then taking longer to pay it off can benefit you because, due to inflation, future dollars are worth less than today’s dollars.
If the debt interest rate matched inflation, then it is a net neutral – you neither benefit nor lose by paying that debt off sooner versus later. (Although you could lose out if you can invest money at a higher rate).
Interest rates that are higher than the rate of inflation (which is nearly every interest rate on any debt) will cost you more the longer it takes you to pay them off. Because of this, you may want to consider paying more sooner if you can. However, this needs to be balanced with what you might gain from potential investments, as discussed in the next section.
Interest Rates and Saving or Investing
There are many ways to save money. You can put it in a savings account or invest it, either by putting it directly into the stock market or a retirement account.
Most savings accounts have very low interest rates. According to the FDIC, the average national rate on savings accounts as of May 2020 was 0.06%, although many high yield savings accounts exist, offering rates of over 1%.
The odds are that the rate on any savings account you can find will be dwarfed not only by the interest rate on your debt but also by the current inflation rate. This is why savings accounts are often best used as places to keep emergency funds or to secure savings that you don’t want to risk by investing.
The historical average stock market return is closer to 10%, although the year-by-year amount can vary widely from this. The S&P 500 averages closer to 8%, and it is possible to lose money in the stock market.
This is why it isn’t wise to put any money in the stock market that you might want quick access to or that you would be completely devastated or ruined if lost. (Even when the market dips, long-term investments almost universally increase.)
When to Choose Debt Repayment Over Saving or Investing
If your student loan interest rate is comparable to current inflation rates, then there is little financial benefit to paying it off sooner, even if you aren’t planning on investing the difference, although you may benefit from the peace of mind of knowing a debt is gone.
Student loan debt is rarely at an interest rate that is comparable to inflation, but there may be times when interest is deferred or subsidized, such as when you are in a grace period for federal Direct Subsidized Loans. But the grace period 0% is not a lasting rate, which means that any remaining principal gains interest as soon as it ends.
What does this mean? Any amount by which you pay down the principal during the 0% interest period will not sit in the account, gaining interest for the remaining lifetime of the loan. So, even though 0% is a super low rate because it does not last, you may still benefit from paying while the rate is that low.
The general rule is that if your student loan debt has a higher interest rate than what you might earn by investing, then it benefits you to pay it off instead. However, if you have any other debts with even higher interest rates, then those should be paid off first to save more money in the long run.
If you are risk-averse and do not plan on investing the extra money and will instead store it away in a savings account, then given the difference in rates, it would make more financial sense to use those funds to pay down your debts instead.
You should also consider whether you might be eligible for certain student loan forgiveness programs, in which case making additional loan payments, regardless of the rates, gives you no financial benefit.
When to Save or Invest Instead of Repaying Debt
If you expect investments to earn a higher interest rate than your debt is gaining, then it almost always makes sense to invest instead of paying off the debt first.
Given that federal student loans often have lower interest rates than stock market averages, it is likely in your favor to invest extra money rather than pay down these loans sooner.
As noted previously, if you have any other debts with higher interest rates, those should ideally be paid off before investing or before paying off student loan debt. Debt with low interest rates, however, may not benefit from being paid sooner.
For example, you may have a 0% financing offer on a credit card or even a 0% promotional rate on a car loan. With rates like that, you can only gain by paying them on schedule instead of early. Beware, however, that sometimes deals like these will apply a very high interest rate retroactively to the entire initial balance if it is not paid in full by a certain deadline, which can be a huge negative.
Keep in mind that invested money cannot usually be easily accessed as needed. This is money you set aside for long-term savings, and you may end up having to pay penalties for accessing it earlier, especially if it is in the form of a retirement account. So, investing instead of saving makes the most sense when you don’t intend to access the funds for quite some time.
Stay Informed About Student Loan Debt
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