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Should You Save or Pay Off Student Loans?

One of the most common questions I get is “should I save or pay off student loans?”

Although it can be daunting to start out with a lot of eduction debt, you may want to resist the urge to repay those student loans as fast as possible.

Earlier I outlined a roadmap to financial success that provides six steps you can follow to prioritize your financial goals. This post  follows up with a real life case-study in which I apply these steps (and go a little further). It’s in response to an excellent question from reader Kaitlyn:

Should I focus on building up my emergency fund and just pay what is due on my student loans until my emergency fund is where it needs to be, or build my emergency fund at a slower rate and go full force at my loans?

In Kaitlyn’s case, she used her student loan six-month grace period to save an emergency fund equal to six months’ expenses. (Nice work). She had planned to make bi-weekly payments on her student loans of up to twice the scheduled minimum payments, but then her situation changed. Kaitlyn moved to take a new job. It paid more, but required moving to a more expensive city. Says Kaitlyn:

I now make a lot more money, but have higher expenses than I previously had (higher rent, higher car insurance, higher amount to put in savings, not on my family’s insurance anymore, higher retirement contributions, etc.). I don’t have the cushy window before my loans kicked in.

So her savings will no longer cover six months’ expenses and, presumably, smaller fluctuations in expenses may impact her more because she has less wiggle room in her monthly budget.

Let’s look at where she falls in the seven steps:

  1. Build a buffer. Kaitlyn has an ample emergency fund (at least for her prior expense level), so she’s obviously all set here.
  2. Invest a token amount for retirement. Retirement savings is something that didn’t come up in her question, but if she’s not contributing at least a little bit towards retirement I recommend starting.
  3. Get rid of bad debt. In my “Steps”, I define bad debt as “credit cards, personal loans, and anything with an interest rate of more than seven percent”. So that sometimes includes student loans. Hence my advice to Kaitlyn: Pay off any loans that have rates above 7 percent, otherwise move on…
  4. Save for emergencies AND start a Roth IRA. A Roth IRA is the perfect complement to an emergency fund because—if you ever face a true emergency—you can withdraw the principal from a Roth penalty-free.
  5. Save for life.
  6. Invest and donate as you see fit.
  7. (a.k.a. Step 6.5) Create an additional stream of income.

Although I didn’t make it explicit in the above steps, paying so-called “good debt” like mortgages and, in many cases, student loans, would fall under step six. Debt, including student loans, is essentially negative savings. By paying it down, you are investing in your financial future just as much as you are when you put money in stocks and bonds. In Kaitlyn’s case, I might pay off student loans with interest rates of 7 percent or more, build out savings for both retirement and other shorter-term “life goals”, and then focus on wiping out the student loans.

Following my steps, I would first ensure I had a small cash buffer and were saving a small amount for retirement. Then I would pay down any student loans with interest rates of 7 percent or more. If the interest rates are lower than that (as is often the case with federal student loans), I would only make the minimum payments on them and focus on 1) building an emergency fund that makes me comfortable and 2) getting money into retirement accounts.

Of course, personal finance is personal, so what would I would do might not work for everybody. (I have a lot of friends who want to be out of debt more than anything else, so in their cases they would pay down the student loans as fast as they could, whatever the interest rate). Let me break down my recommendation:

Before you rush to pay off student loans, consider saving first.

1. Over the long run, your investments can (hopefully) earn six or seven percent. With some sound investing and a little luck, average annual returns in the stock market can match — and maybe beat — the interest rates on your loans. And the sooner you start investing, the longer it can grow.

2. Some student loan interest is tax-deductible. It’s still no fun paying interest, but the student loan interest tax deduction only adds to the fact that your money could work harder for you if you invest it.

3. Liquidity is a good thing. (This is important!) On paper, it doesn’t matter if you pay down your student loans early or put cash in the bank: your net worth increases by the same amount month after month. But, let’s assume the worst. God forbid you lose your job or you need a life-saving operation? The more cash you have on hand, the better prepared you’ll be to deal with such a big financial setback. If you’ve paid off half of your student loans early, you’re 1) still going to have a minimum payment to worry about until they’re paid-in-full and 2) not have as much cash on hand.

4. You can start saving for other goals. Again, if being totally debt-free is your financial priority because you don’t like the principal of debt, that’s fine. Personally, I don’t see anything wrong with paying off student loans over a period of 10 or 20 years, especially when it’s a conscious decision.) During that time, you can save money for other things you want (travel, a home, a car, further education, etc.) and pay for them in cash.

So that’s my take: Save a little bit of an emergency fund, pay off student loans great than 7 percent, then focus on retirement and other savings goals while making minimum payments on the other student loans.

About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. Stephanie says:

    THANK YOU FOR THIS POST! I’ve asked this same question several times on other personal finance blogs in the past and always got the “it depends” answer without any clear cut steps to consider. This is an extremely clear set of recommendations :)

  2. Great article! I love the way you showed your steps in action. It really shows how good this course of action is!

  3. David, I really like your approach here! Too many people would tell the person in your case study to pay down (as fast as possible) all the student debt. I totally agree – cash is KING! When the Economy is as bad as it is, it always good to have a strong cash buffer. Being debt free doesn’t mean you won’t end up on the streets still.

  4. Halothane says:

    Great post! Thanks for it. I’m in a somewhat similar situation.

    -30K on a car loan with a too high interest rate.

    -10K left in student loans.

    -No credit card debt.

    -$1500 emergency fund in the bank.

    -Contribute 6% of salary to 403B with 100% company match.

    My question is that I am getting ready to apply to a graduate program that will require me to take loans out to attend not only the program but also to live off of. Trying to decide whether to save, save, save, or to pay that car off.

    What are your thoughts? I’m 26 and currently required to work 24 hours per week but I have been working 60hrs per week for the past 6 months to pay off other debt and education loans.

    Any ideas would be fantastic!

    • Just a quick question, but if you are looking at graduate school and basically have a part time job (i know you have been working overtime however), why did you buy a $30,000 car? I would look at selling it and buying a car 1/3 of the price, and then start saving $ to at least live off during graduate school. Sounds like you will still need a loan for the tuition, but if you can at least save $ for living expenses you will be better off.

    • David Weliver says:

      Hi Halothane, If your estimate of the auto loans interest rate is “too high”, then my advice would be to pay off the car! Will’s advice to try to sell it and buy one for a third the price isn’t bad. That may be an emotionally very difficult thing to do—and you’ll probably take a loss on the car—but even if you could sell that car for $20k and buy a used one for $10k, you’d still owe $20k on the car but would be $10k better off.

      Despite what I said about preferring cash over paying down student loans early, I think you would find it bothersome to enter grad school—living on loans—and still paying a huge car payment. Good luck.

  5. Great tip! Thanks for your input. Being a recent graduate myself, I really appreciate it.

  6. Shery deWinter says:

    What would you do in my case?

    I have a 6,000ILS debt to the bank (I live in israel). I pay about 5% in most of it, and 15.5 (yearly, calculated monthly) percent on a third of it because I haven’t been able to meet my payments.
    On top of that I have a 500ILS debt to cover ASAP or they’re taking me to court.
    In addition I have another 14,000ILS I owe to private people.

    … and I’m unemployed.

    Where would be the best place to put money in once I do manage to get some sort of an income?

  7. Thanks for this post! It’s much easier to relate when reading about real experiences. You offered some great suggestions!

  8. Great post David. I would add that student loans should be broken into several others loans, because the odds are we have federal loans of different interest rates as well as private loans. Oddly enough, my private loans go at 3%, whereas my federal loans go at 6.8%. So I would look at the strategy to pay off the minimum for the cheap loan, and pay more money for the more expensive loan.

  9. I spent the last two years loading up my investment fund, but now think its time to get rid of that student loan. I could go on for years paying the monthly payment, but I want to get rid of it, largely for nothing more than happiness. Getting rid of a student loan is something I look forward to!

  10. Thanks for the great article! I’m transferring programs and right now I’m trying to pay off as much as I can of my student loans before I add to them.

    I was throwing all “leftover” money at this goal but now I’m thinking of putting half of the leftover money towards it and the other half to other goals. So, thank you for the food for thought.

  11. This is a great article! I was not sure if I should pay down my student debt or focus more on investing. This article makes a good arguement. I agree with you. Thank you for writing this!

  12. natalie smith says:

    Hi! I owe $75,000 in student loans and I just starting working last September. I only make $32,000 as my starting salary. So I decided to live at home until I could buy a better car (my car was 19 years old) and so I could save money. I took a 1 year forbearance to save money to put down on the car so I would be able to get to work. Basically, every check I get I put away would pay for rent if I was living on my own. I think because I don’t make much money in comparison to my loan debt I should do the income based repayment plan when my forbearance is over. The IBR would make my monthly payment around $200, and it would increase as my income increases. I would make the payments over 20 years. I think it is better for me to have cash on hand (or in my savings account) than to be low on money every month trying to pay student loans.
    What do you think?

  13. Hi David!

    I really enjoy reading all of the tips you have given people and was wondering if you could give me some pointers for my situation. I am 25 years old, just finished grad school and have 90,000 in student Debt with interest rates no higher than 6.8%. My wife and I make roughly 6,000 a month after taxes. We have been putting $300 into retirement a month and have roughly $20,000 saved up. We put $200-$300 a month into savings and have $8,000 in the bank. We have been struggling to decide whether to pay off student loans ASAP (5-6 years) or have a more balanced approach by putting more into savings and retirement. The reason I ask this is because we are looking to have kids in 2-3 years and don’t want to feel swamped by student debt. In our situation what would you say is a safe amount of money to have in savings/retirement? We live a very modest life and the only other debt we carry is 7,000 dollars on a car with low interest and a mortgage with low interest. Any advice would be great.
    Thank you!

  14. I have to say, my decision was made not just from a financial perspective but because Sallie Mae is a terrible, terrible administrator of federal student loans. I ended up paying off the balance when I would have otherwise preferred to keep the liquidity, so I wouldn’t have to deal with them.

  15. That chart is fantastic. I’ve read many articles exploring this topic, but I’ve never seen a graphic or illustration that describes the issue as well as your depiction of a see-saw did.

    You’re right — liquidity and cash is important, since it can ward off the negative financial outcome from unexpected events like emergency surgery. And while paying interest is unpleasant, the tax-deduction on student loans is a nice bonus.

    That said, let’s also remember that while your money may earn decent returns in the stock market in the long-term, those returns are also subject to taxes and fees. So even if your interest rates on your loans are slightly lower than the long-term market returns (7 percent, as you state here), the combination of taxes, fees, and risk might make a stronger case for paying down debt, even if the interest rate on the note is only 6 percent or even 5 percent.

  16. Melissa says:

    Can this philosophy be applied to making extra car payments vs. saving for a house as well?

    • David E. Weliver says:

      Unless you have 0% or maybe 1.9% APR on your car loan, I’d recommend paying off the car loan before focusing on the house. When you save for a house, most of us stick with savings accounts (rather than invest that money and risk it), so you might be paying 4, 5, or 6% on a car loan and earning less than 1% on a savings account. The other part of it is when you go to apply for a mortgage you’ll want to have as little debt as possible, so paying off the car loan early is a good move.

  17. I am focused on getting rid of my giant student loan debt. I think this is the worst debt I have and my goal is to eliminiate it ASAP.

  18. Inflation and negative amortization of student loan debt are additional factors to consider when assessing how much student loan debt to pay off. This is because an inflation rate at or below the loan’s interest rate helps keep the actual adjusted dollar cost of the loan steady.

    What’s more, if a higher rate of interest can be earned on savings than one pays in loan interest, then an opportunity cost exists by not taking the savings options. This opportunity cost is the amount of possible savings interest after loan debt interest expenses are deducted.

    On the other hand, not paying a student loan that is unsubsidized can incur negative amortization which means the balance of the loan that is charged interest grows. This causes the cost of debt to rise continually until an alternative such as interest only payments is implemented.

  19. gigi Larue says:

    Do government loans dissipate after a certain amount of time if you work in the public health field, say, as a nurse?

  20. I like to think of student loan debt payments as annuitizing the amount paid. Money that is used to pay student loan debt “saves” you the interest on that debt; however, you will never see the principal again. Given these characteristics, paying off student debt acts as a risk free stable income stream with no liquidity. Because old student loan interest rates are currently often higher than 10 year investment grade bond rates, paying off student debt may be a better investment than purchasing bonds; however, I agree with David that saving for emergencies and paying off “bad” debt should come before trying to build up a steady income stream (pay off student debt). If interest rise substantially and inflation increases materially, stocks may be the place to park money instead of paying off debt as debt decreases in value during inflation. This is by no means a cut and dry issue but all of that said paying off student debt should only be apart of a long term savings strategy and not come before retirement and personal fund savings.

  21. Jennifer says:

    I have student loans finally under $25,000 and make payments on time but not much more than the minimum payment. I have really good credit and have minimal credit card debt. Working for a non profit, I’m not making much money at all, but want to pay off as much as I can so I can finally put money in savings again. I was wondering how to reduce the number of credit cards open, without too much damage to my credit, so I can maybe refinance the student loans for lower interest.

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