Happy Friday – and almost long weekend! Today I’m going to tackle one of the hardest questions that newly graduated young folks face, and that’s whether to focus on paying off loans or save for retirement (or both).
I was inspired to tackle this question because of this viral (for the financial community, anyway) controversial Twitter topic.
People reacted strongly to the idea of a “one size fits all” approach that delays potentially getting free money (in the form of a 401k match) to pay off loans that might take decades to disappear.
So today I’m going to tackle how to think about that question, and ask for your opinion in the comments.
But before we get to that..
Last Week’s Responses
Last week, I tackled the question of what to do when you’re on a path to financial freedom (or desperately want to get on that path), but have a spouse who isn’t on board. I shared that this was my personal situation back when my husband and I first got together, and over time through education, patience and compromise we’ve gotten on the same path.
Here’s what readers had to say:
- Financial Fitness Fanatic talked about how she’s gotten creative with alternatives to going out and spending money – like doing something special at home. I loved this, as it goes perfectly with two things I like to talk about – “making the ordinary extraordinary”, where you take something ordinary like dinner at home and make it special; and that “frugality without creativity is deprivation”, a saying I first heard in one of my favorite books, The Tightwad Gazette
- Svsabbattical loved the tip to focus on dreams, and shared how she’s leveraged what Thomas Stanley of The Millionaire Next Door would call an “environment of artificial economic scarcity” (fancy way of saying putting money aside so it can’t be spent) to help her family reach their financial goals.
- Much Happier Now! Talked about an experience where she and a significant other were at odds over financial priorities, and eventually broke up. This is a good reminder that sometimes we can’t overcome these differences.
- Tara discussed how it’s important to listen – really listen – to the other person when talking about money. This is so true, active listening (rather than listening with the intention of telling them why they’re wrong) is important to addressing differences in a relationship
Now, on to the question about saving for retirement over paying back student loans!
The Question: Do I Focus On Paying My Loan, Or Do I Invest For Retirement?
I recently graduated from college with $30,000 in student loans at around a 5% interest rate. I’ve been in my new corporate job for a few months so far, and it’s great! They have some great benefits, including a 401k match of fifty cents on the dollar up to six percent of my income. But I hate this debt! Do I focus on paying off the loans, or do I contribute to retirement and pay off my loans more slowly?
Pay Off Debt Or Invest For Retirement – A Framework
Here at CMO I’m less about just answering a question (especially a specific question) and more about teaching my readers how to create a framework to think about questions like this.
Why? Because a specific response to this specific question would help one person – but wouldn’t help everyone. Instead I’ll walk you through how I would approach the question of paying off debt versus investing.
It would be easy for me to say “do both!” but I would be catching a (wo)man a fish rather than teaching her to fish. I recognize fully that saying “do both” can be tone deaf, especially if someone is already struggling just to pay the minimum on their loans. It’s like telling someone who earns $30k per year to max out their 401k. Maxing out a 401k costs $19k…
So let’s talk about how to best think of this question. I would suggest asking yourself – and honestly answering – a series of questions.
- What is the interest rate on your debt? In this question it’s a student loan, at a relatively low interest rate. If the interest rate was much higher, the answer might be different.
- Is this debt tax deductible? Potentially, in this case (check this out for more on that). If it’s credit card debt, a car loan, a payday loan or the like then it’s not tax deductible. A mortgage might be tax deductible, but not for most people anymore.
- Is this investment tax deductible? If so, then you’re able to put aside a dollar into your account, but spending less than a dollar to do so.
- Am I getting a match on my investment? In this case, the person is getting a 50% match for every dollar they put away in their 401k. Since they’re so young and likely have so many years to go before retirement (assuming they’re not planning to retire at a very young age), this investment plus the match are going to compound greatly
- Could this loan be forgiven? If you’re eligible for the student loan forgiveness program, it could make more sense to pay the minimums and invest any extra.
- How long will it take to pay off the debt? If the debt is relatively small, or you have a high income, you might be able to get rid of it quickly. In that case, you might not miss out on much of a match or compound interest, and you may want to knock out the debt. But if it’s a higher amount, or you have a lower income (aka smaller shovel), you could potentially miss out on years of growth by delaying investing.
- Can I afford to do both? This is going to depend on the size of your payment, income, and other expenses. You may be able to afford to pay off debt aggressively and invest for the full match. Or maybe you can pay off the debt a little early and still get the match. Perhaps you’re maxed out just trying to pay your minimum payments and need to focus more on growing your income. Take a hard look at your budget and see what you can free ups
Answering these questions for your specific situation will help you decide the path that’s right for you.
A few tips:
Run the numbers. Here’s a student loan repayment calculator, and here’s a 401k calculator. Try running a variety of scenarios with extra payments, no extra payments, and different contribution amounts to see what a difference they’ll make in the long run.
Make a budget and monitor your spending. You need to know how much you have to work with in order to decide if you can realistically both invest and pay off debt. Monitoring your spending for at least a month will also show if your spending is truly in alignment with your ultimate goals and dreams – or if there’s something you could cut back to make your dreams come true.
Try a bit at a time. If you think you might be able to do both, but aren’t sure, give it a try for a month. You can always start with a small 401k contribution – one percent, or one cent for every dollar you earn – and ramp it up a percent at a time until you reach the full match potential. If you find it’s not manageable on your budget, you can always cut back later!
Chime In!
Readers, what do you think of the question of whether to focus on one thing (paying off loans) as opposed to splitting your focus and starting to put money aside for retirement at the same time? Let us know in the comments and yours might be selected to appear in the next “ask the readers” article.
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I just ran a mock budget to ponder this, and the realization is both goals will take time. The math supports starting early in your career on a 401k. There are the added advantages of the company match, and tax deferred money. I understand wanting to be free of the debt, but it took a few years to get into $30k, give ‘yourself’ a break and know it will take a few years to get out of it.
Because you can’t make up for not putting into your 401k at a later time, I agree with CMO’s idea to start with 1% (or more). Often the debt can have additional payments from unexpected money, which could potentially be a side hustle if that’s something a person wants to pursue / makes financial sense.