“I have student loans and extra cash – what should I do?”

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Student Loans

If you are like many young adults, you have student loans. Some are ashamed of their loans and are afraid to admit it publicly. But student loans should not be a source of shame, primarily because they represent an investment in the most important asset you have: yourself. One study found that people with college degrees earn on average $1M more in their lifetime compared to their counterparts without degrees. So according to this study, if the total financial cost of your student loans (principal and interest) is less than $1M, then it was likely a good investment.  By choosing to not attend college in order to avoid student loans, you will likely stunt your earnings potential over the course of your life. 

So now what? You have student loans and perhaps your education has enabled you to find a good paying job. What should you do with your extra cash? Should you pay off your student loans rapidly, or should you pay the minimums until the loans are repaid after 25 years? 

The answer lies in the classic economic principle: opportunity cost. As an economics refresher, opportunity cost represents “the benefits an individual, investor or business misses out on when choosing one alternative over another.”[1] It is the unseen cost of spending a dollar when you could have spent it elsewhere. A dollar spent here is a dollar that could have been spent there. 

If you have disposable income, what is the highest and best use of those dollars? Is accelerating your student loan repayment the highest and best use of your extra cash? Maybe. 

By paying off your student loans early, you earn a rate of return that is equal to the interest rate on your student loans. Let’s assume the interest rates on your student loans are near the current federal rate of 4.53% for undergraduate student loans.[2] If you were to pay off your loans early, you’re avoiding future interest rate payments at 4.53%; that is the same thing as earning a 4.53% rate of return on your extra cash. The question becomes, is a 4.53% rate of return the best rate you can earn with that money? Historically, the answer is no. The S&P 500 index, which tracks the performance of 500 of the largest companies in the US, has averaged a 10% annual rate of return since 1926.[3] Past performance is no guarantee of future performance, but if these sort of returns were to continue you would be in a better position financially if you invested your extra cash in these companies than if you paid off your student loans early. The opportunity cost of paying off student loans early is what you could be earning in the stock market. 

Where does one begin investing? There are many different places where you can begin to invest extra cash, but a common place to start is with your employer’s 401(k) plan. Not only are there tax advantages to contributing to your 401(k), but there could also be added incentive if your employer provides a matching contribution. The opportunity cost for student loan repayment becomes even greater if the company you work for provides a match with their 401(k). A “match” means that the company will put extra money into your 401(k) if you contribute some of your own income to the 401(k). A common matching structure is 50% of what you invest until your total contribution reaches 6%. That means if you put 6% of your pay into your 401(k), you will get an extra 3% from your employer.

To illustrate the opportunity cost, let’s use assume your income is $40,000/year and you set aside 6% of your pay into your 401(k). That would be $2,400 set aside throughout the course of the year. With a 3% match, your employer would contribute another $1,200. At the end of the year, assuming no growth (even though the stock market has averaged around 10%- see above), you would have $3,600 in your 401(k) and you would have only invested $2,400 of your own money. What is the rate of return on your money in this scenario? A 50% rate of return. If given the choice between earning 4.53% on your money by paying down student loans early or earning a 50% rate of return on your money by contributing to your 401(k), which is better? Certainly a 50% rate of return is better than a 4.53% rate of return.  

Therefore, unless the interest rates on your student loans are exorbitantly higher than the national average, the math would suggest that it is financially advantageous to capture your company match and invest in the stock market before paying off your student loans early.  

However, there is an emotional component to debt as well. For some people, debt is very stressful and creates anxiety in their life. In that case, it might be better to accelerate the loan repayment for the sake of your emotional health; the opportunity cost in this case would be greater by not accelerating your student loan repayment because you would be hurting your emotional well-being. What you decide to do will be based on your personality type, personal convictions regarding debt, views on investing in the stock market, cash flow planning and other factors. 

Using extra cash to pay down student loans is certainly financially better than blowing the cash on luxury items you don’t need. The math we discussed above only works if you have the discipline to invest your extra cash rather than spend it. If you lack that discipline, then you will benefit by paying off your student loans early. 

Logan Jones
Partner & Wealth Manager CFP®, CIMA®, CPWA®, CEPA

[1] https://www.investopedia.com/terms/o/opportunitycost.asp

[2] https://studentaid.ed.gov/sa/types/loans/interest-rates#how-calculated

[3] The Dimensional Matrix Book 2019