The average college student graduating with loans in 2015 faces around $35,000 of debt. The idea of planning for retirement straight out of college sounds like a distant dream. I’m a big advocate of long-term financial planning at a young age, but when I bring up retirement savings with recent grads, they say they plan to put it off until they’ve finished repaying their loans. That’s not necessarily a good idea.
Here’s why: let’s assume that after your child makes minimum payments on her student loans, plus other expenses, she has an extra $100 at the end of the month—or $1,200 at the end of the year. If she puts $1,200 into index funds in a retirement account like a Roth IRA, that money will grow tax-free for the 40-something years before she retires. At an 8% growth rate over 40 years, that $1,200 will turn into over $26,000. Pretty cool, right? This year-over-year growth is the power of compound interest.
Now, say she decides to put that extra $100/month toward paying off student loans. Getting rid of student loan debt early sounds pretty great, and if her loans have an interest rate over the 8% used in the example above, she’s probably better off making those extra loan payments.
This is because the absolute amount she will spend repaying student loans will surpass the absolute amount she can gain by investing that money. If her student loan interest rate is 10%, contributing an extra $1,200 this year saves her from paying over $5,000 in interest over the next 15 years. Investing that $1,200 over the next 15 years at an 8% interest rate will only yield about $3,800 in interest. So by prioritizing student loans, she saves herself an extra $1,200 over 15 years.
The easy way to remember this rule: if your child’s highest student loan interest rate (10%) is greater than her expected return in the stock market (8%), she should prioritize student loans. If her student loan interest rate is relatively low—3.5%, for example—she’s better off investing that extra cash in retirement. Remember that interest on student loans is often tax-deductible, which lowers its effective cost. Somebody in the 25% tax bracket would have an effective cost of 3.5% interest on a Stafford loan with a 4.66% interest rate, because they are using pre-tax money to pay that interest.
A note: if your child’s employer offers a 401(k) with company match, that’s free money on the table—she should take it. After making minimum student loan payments, of course! A common policy is dollar-for-dollar 401(k) matching up to 6% of your pre-tax salary. If she makes $50,000/year and contributes 6% ($3,000), her employer would put an additional $3,000 into her retirement account. Or, using her extra $1,200 from the example above, her employer would contribute an additional $1,200. After 40 years of growth, her $1,200 contribution puts her ahead by an additional $26,000—without spending a dime.