As the New Year rolled in, student loan borrowers and their amount of debt continue to increase. According to this article from LendEDU, over 44 million Americans have Student Debt (60% of recent College Grads). The total owed exceeds 1.4 trillion, and the average student loan debt per borrower is ~$30k and climbing.
There are many student loan repayment programs available today. Income-driven repayment is widely used and helps millions who struggle meeting the minimum payments on their student loans.
However, there is a debate on which is the best strategy for borrowers that have the means to accelerate their payments.
- Pay off Student Loan Debt ASAP. Throw all additional money towards student loans. Invest in Company 401k match (if available)
- Focus on Investing in Tax Deferred Retirement Accounts while paying the minimum balance on student loans
- A mix of both (Hybrid). Paying off High-Interest student debt aggressively, paying low-interest debt slower while focusing on investing
- Building a 6-month Emergency fund, then following one of the strategies above
No matter which option you choose, I recommend refinancing your student loans to a lower interest rate if possible. You can save thousands of dollars by lowering your interest rate a few % points. Check out LendEDU* to see which refinance company can give you the best deal.
Now, let’s review each option.
Paying off Student Debt ASAP
Paying off your Student Loans ASAP is probably the most popular choice. It was made famous by financial guru Dave Ramsey.
Ramsey recommends for people with consumer or student loan debt to keep $1k in the bank (for emergencies) and throw all extra money towards debt. He recommends using the Snowball method, which means to pay off the lowest balance first, then “snowball” your payments to the next lowest amount. The main reason he recommends paying the lowest account balance first to start getting “quick wins.”
Having debt is an emotional experience, so gaining “quick wins” helps motivate people to stay the course in their debt payoff journey.
You can also follow the Avalanche method and focus on paying your highest interest debt first. You still are prioritizing debt over everything else, but saving the most $$ in interest over the term of your loan (not necessarily getting “quick wins”).
I recommend using this Debt spreadsheet to determine the most efficient way to pay off your debt.
Ramsey doesn’t mention investing in your company 401k match in this debt payoff step. However, if you work for a company that matches your 401k contributions, you should always invest up to what they match. 401k matching is free money and should be utilized, even when you are focusing on paying off your debt aggressively.
Pros to Paying off Student Debt ASAP
- Freedom of debt hanging over your head (Emotional Win!)
- Less student loan interest paid and faster repayment time
- Develop financial discipline in the process
- Increased cash flow after debt is paid off
Cons to Paying off Student Debt ASAP
- A small margin of error with less money saved. An emergency (Job loss, medical or car) can put you in a financial hole.
- Missing out on building wealth with investing
Focusing on Investing in Tax-Deferred Retirement Accounts
This option is attractive for the people who are more math oriented and don’t mind delaying debt freedom. The math shows that if you take the extra money you were allocating towards paying off your student loans and invest it in a tax-deferred retirement account (401k or IRA), you will be building more wealth in the long run.
For example, say you have an extra $500 to allocate to your student loans. Your interest rate is 5% so by paying $500 extra you will save $25 towards interest. If you allocate $500 towards a tax-deferred retirement account: the $500 will automatically be worth more because it is pre-tax money (lowering your income tax bill), and your money will be earning interest by investing (total stock market index funds tend to average about 7% per year).
Also, student loan interest is tax deductible up to $2500 a year (1098-E tax form). So if you pay the minimum balance and end up paying $2500 in interest payments, for example, you would receive a refund of about $600. So in effect, it lowers your student loan interest rate from 5% to closer to 3%.
Pros to Investing focus
- More Wealth built up and compounding for longer period
Cons to Investing focus
- Emotional impact of keeping debt balance
- Can’t use money until retirement – 59.5 (unless using advanced strategies like Roth Conversion latter for early retirement)
A mix of Debt Payoff and Investing (Hybrid Approach)
The Hybrid approach is the happy medium of both strategies listed above. Typically, people who do this focus on aggressive payments towards Student Loans that are over 5% interest. Once they pay the high-interest student debts, they pump the breaks on student loan payments and increase their % towards tax-deferred retirement accounts.
Pros of Hybrid Approach
- Overall less interest paid then focusing on tax-deferred investing 100%
- More wealth built up than 100% focusing on Debt payoff
Cons of Hybrid Approach
- More interest paid than focusing on debt payoff 100%
- Less wealth built up than 100% focusing on tax-deferred investing
Building 6 Month Emergency Fund First
This option is attractive for people who aren’t willing to have less security in the short term while paying off their Student Debt. By having a 6-month emergency fund, you have a nice cushion to recover from if something happens- like losing your income in one way or the other. This strategy gives you financial peace of mind before aggressively paying off your Student Loans or Investing.
6 Month Emergency Fund Pros
- Financial peace of mind
6 Month Emergency Fund Cons
- Delayed start, more student loan interest paid and less wealth built
My Student Loan Strategy
As mentioned on my About Me page, my sister influenced my student loan/debt-free journey. She ended up paying off ~100k in 18 months by following the Dave Ramsey plan with her husband. She introduced me to his strategy, and it motivated me to become debt free ASAP.
Per the Dave Ramsey plan, I started with $1k in emergency savings and followed the Snowball method to pay off my debt aggressively.
For the first year I didn’t invest in my 401k plan at work (I didn’t get a company match option until I worked one year). After a year, I started to contribute towards my companies match of 6% on my 401k.
I used the debt reduction spreadsheet and determined I should be using the Avalanche Method to pay off debt by highest interest rate first. I also began tracking my money with Mint.com and found some ways to reduce spending and increase my student loan payments.
In 2016, I raised my monthly payment average to $1551 per month. Towards the end of the year, I started to grow my emergency savings using my Capital One 360 Savings Account* and automatically contribute money monthly to build my emergency fund and other funds. I realized that only having $1k in my emergency fund was leaving myself too thin in case of an emergency. If I were to go back in time, I would try to have a bigger emergency fund first while aggressively paying off debt.
2016 Student Loan payments from Mint.com
So far, as of January 2017, I have paid off over $50k towards my student loan debt and will pay them off in full in March. For me, I value being debt free right now. Since I am so close to the finish line, it will be a significant milestone once I pay off my student loans.
I recognize that investing earlier in my journey would have been a smart move, but overall I am happy with the idea of being debt free ASAP. I have paid a total of a little over $5k in interest in the last three years. If I had taken a less aggressive path, I would have paid much more in student loan interest.
After paying off student loans, I plan to allocate the money I was paying my student loans towards to 1. Building up my Emergency Fund fully and Savings Goals 2. Increase my Retirement Savings % (401k and Roth 401k), Max out Roth IRA and eventually Max out 401k too.
My favorite part about writing about personal finance is that it’s still a “Personal” choice. At the end of the day, it’s your choice to make the best financial decision for your situation.
What is your preferred way to pay off debt? And Why?