If you’ve reached this page, you deserve congratulations. You’re debating whether to pay off your student loans or to put your spare cash into investments. It’s worth mentioning straight off the bat that either decision is a prudent move towards a healthy financial future.
But while both moves are a wise first step towards financial security—especially when another option is simply spending your extra cash—they’re not exactly equal. There are several factors to bear in mind when considering this financial move, including interest rates, your amount of debt, and even your age. While your initial impulse may be to clear out your debt before investing, this isn’t always the smartest move.
Before you go pouring all your excess funds into student debt repayments, we’ll break down everything you need to consider when facing this major financial decision.
Should You Pay Off Student Loans or Invest? 8 Things to Consider
As much as we’d like to offer one time-tested and universal piece of wisdom, every financial situation is different. What works best for one person could spell missed opportunities for another. So, to aid you in your decision-making, we’ll spell out eight major factors you should weigh when debating whether to pay off student loans or invest.
#1 Emergency Fund
First and foremost: before putting your extra cash in one place or another, your financial priority should be to establish an emergency fund. This fund should hold enough money to keep you going for three to six months if you lose your job or fall ill. (If you’re a freelancer, that number should go up to eight months.)
While it may seem wise to clear out your debt now, you may find yourself regretting that decision if you have an emergency and no funds to fall back on. And this lack of funding can affect you in more ways than one.
“If you pay down debt but leave yourself with little to no liquidity, you may miss out on other investment opportunities in the future, or you may be forced to draw a loan at an even higher rate in the event of a large expense such as an emergency,” Brian Dudley, senior vice president and financial advisor at Wealth Enhancement Group, told U.S. News & World Report.1
But this emergency fund doesn’t have to just sit in your savings account gathering dust. You can put it in a place where it will yield more interest, like a:
- High-yield savings account
- Money market account
- Certificate of deposit
- Roth IRA
Wherever you put your emergency money, make sure it’s a low-risk and high-liquidity investment. That means you’ll make money on it and you’ll have easy access to it, in case an emergency does strike.
#2 Interest Rates
Typically, the largest and most influential factor in the decision to pay off loans vs invest is the interest rate on your student loans. A good rule of thumb is that your investments should bring back more in returns than you’d be losing from the interest rates on your loans.
Here’s one example of when it would be more prudent to invest rather than pay off your loans:
- You’re considering investing in the S&P 500 Index Fund. Although there is always some risk in investment, the index has an average annualized return of 11.88%.2 (Meaning that, although every year is different and some years will soar while others plummet, you can expect to make about 11% of your investment back in returns.)
- While you’re considering this investment, imagine that you’ve also got a student loan with a 5% interest rate.
- While you will lose money when paying that interest rate of 5%, your 11% return will more than make up for it.
The magic number to remember is 6%. Generally, any loans with interest rates less than 6% are not bad loans to have. You can probably invest and make more money than you’d save by carving off interest payments. However, savings aren’t guaranteed for any interest rate higher than 6%. You may want to use a financial calculator and crunch the numbers to get a more detailed picture of how much money you could make in investments.
If your loan comes with a high interest rate (over 10%), you’ll want to pay that off as quickly as possible. There aren’t many investments that will make up for that loss.
#3 Federal Loan vs Private Loan Types
One of the biggest factors affecting the interest rate of your student loan is whether you’re paying a federal or a private loan.3
Federal student loans generally come with:
- Lower interest rates
- Fixed interest rates
- Tax-deductible interest
- No prepayment penalty
- No need to start paying until after graduation
Private student loans, however, are more likely to have:
- Variable interest rates
- Prepayment penalties
- No option to consolidate
Generally speaking, you’re under less pressure to immediately pay back your loan if it’s a federal loan. But if you’ve got a private loan, the amount of interest that you pay can vary with the market. This could mean that your student loan interest rate could unexpectedly skyrocket one year.
If you have a private loan with a variable interest rate, you may want to pay it all off while you have a lower interest rate.
#4 Financial Goals
Your plans for the future also play into this important financial decision. Consider if your goals are:
- Retirement savings – People looking to set aside money for retirement should aim to eventually set aside 15% of their income. Even if your student loan interest rates are low, if retirement is a high priority, you’ll want to start loading money into your IRA before you funnel it into the stock exchange.
- Home mortgage – If you pay off all your student loan debt now, it will increase your credit score. That could help you qualify for a lower-rate mortgage down the line.
- Living debt free – For many people, living life debt free is a major life goal. If that includes you, live your dreams and clear out your debt before you move on to investing.
If you have a stable income and know where your cash will be coming from (and how much of it will be coming in) for the foreseeable future, you may feel confident enough to invest now and pay off loans later (of course, you should still regularly settle the monthly payment).
That said, if you work as a freelancer or have a less predictable source of income, consider paying off your loans when you’ve got a good amount of spare cash. If you can fully erase your debts now, your future self will thank you when faced with a tighter-than-average month down the road.
Remember that investments are not a surefire way to make money. But once you pay off a debt, it is gone forever.
If you’re living on a tighter budget, you’ll probably want to pay off your debt completely before moving extra money to investments. You should be on completely solid financial footing before investing. After all, there is always a risk that you could lose money.
Some personality types just sleep better knowing that they’re debt-free. If you’re craving the mental release of freedom from your student loan debt, go do that. You can rest easy at night knowing that you’ll be able to make greater investments once you’re free from debt.
However, if you’re more comfortable with risks and can psychologically handle the volatility of the stock market, consider making the investment. You may be rewarded with an unexpected chunk of change in the future.
#8 Credit Score
Does paying off student loans help credit score ratings? If you have a poor credit score and you’re looking to bump that up, one of the most efficient ways to do that is to pay off your outstanding debts.
A higher credit score opens up access to many future benefits, including:
- Lower rate mortgages
- Reduced interest rates on credit cards
- Greater chances of approval on renting applications
- Better rates on insurance
- Approval on higher credit limits
- A positive impression on job applications
Bottom Line: When to Invest
If your finances are in order—meaning, you’ve got a substantial emergency fund and enough monthly income to make your student loan payments—and you have a student loan with a low interest rate, consider funneling some of your money into investments.
Before you make these investments, schedule a meeting with a financial advisor. They can help you decide which investments make the most sense for your financial situation.
Bottom Line: When to Pay Off Student Loans
If you’re facing a high student loan interest rate, you’ll want to whittle away at that before you start making any investments. You may also want to consider student loan forgiveness programs or refinancing your student loans in order to start paying a lower interest rate, but it’s important to understand the pros and cons of refinancing student loans.
Pay Off Student Loans Faster With a Sale-Leaseback
Of course, when you’re wondering, “Should I pay off student loans or invest?” it’s also helpful to know that these are not your only two options. You may have assets that you haven’t even considered tapping into, like your home equity.
A solution like a sale-leaseback program allows you to convert your home equity into cash that you can use in any way you’d like, including to pay off your debts. There are a variety of sale-leaseback benefits, and when you sell your home to us, you:
- Receive a fair market price
- Continue to stay in your home
- With some programs, have the option to buy back your home
That way, you can free up cash to both make future investments and knock out your student loans. Speak with a financial advisor to see if this solution might make sense for you.
- If you expect to earn more in returns than you’ll pay in interest on your student loans, you’re probably good to invest.
- Consider investing if your student loan has an interest rate of 6% or less.
- No matter what you decide, investing and paying off debt are both excellent financial decisions. Either move can serve you more than just spending your money.
- U.S. News & World Report. Should You Pay Off Student Loans or Invest for Retirement? https://money.usnews.com/loans/student-loans/articles/should-you-pay-off-student-loans-or-invest-for-retirement
- Investopedia. S&P 500 Average Return. https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp
- Federal Student Aid. Federal Versus Private Loans. https://studentaid.gov/understand-aid/types/loans/federal-vs-private
- Money. Investments vs. Student Debt: Where to Put Your Extra Cash. https://money.com/pay-off-student-loans-or-invest/