Pay Off Your Student Loans Or Invest? An Opportunity Cost Analysis

Imagine you had roughly $25,000 in student debt, and the equivalent amount in cash on hand. Do you take the $25,000 and pay off the debt?

If you go that route, then that $25,000 is not available for investing – or emergencies.

Like many financial decisions, there’s no “right” answer for all, but understanding the facets of the payoff versus invest decision makes it easier to chart the course that’s right for you.

Interest Rate on the Debt vs Investment Returns

The first factor to consider is your interest rate. The higher the interest rate on the student loans, the more the scale tips in favor of paying off the debt. If the interest rate on the loans is lower, it may be financially beneficial to pay off the student loans more slowly.

On the other hand, if you expect the return on your investments to be higher than the interest rates on the debt, then it may be financially beneficial to hang on to the low interest rate debt and invest. Just keep in mind that while you can predict with certainty what your interest rate is going to be, predicting the future returns on your investments is not as easy.

So how do you estimate your long term investment returns?

While it’s impossible to predict your future investment returns, we can look at historical market performance as an indicator.

For a simple portfolio return calculation, let’s assume you’ve got a portfolio that is 60% stock and 40% bonds. (Note: it’s generally better to have more asset classes in your portfolio). For stocks, let’s use the long-term compounded annual growth rate of the S&P 500 (9.8%). For bonds, let’s use the compounded annual growth rate of the last 5 years (1.5%) to be more conservative. That gives you an expected portfolio return of 6.5%.

Is that higher than your student loan rate?

Can You Deduct the Student Loan Interest Payments?

But wait – the math doesn’t stop there. You may be able to deduct interest you pay on a qualified student loan. Generally, the amount you may deduct is the lesser of $2,500 or the amount of interest you actually paid. If you’re in a 30% tax bracket, have 5% deductible interest on a loan, the effective interest rate is 3.5%.

This is another factor in the paying the loans off over time. If you can get a tax deduction each year, it may be beneficial to pay your loans off over time.

Free Money Consideration

As if this decision wasn’t already complicated enough, there’s one more factor to consider: Does your employer match your investment into the company 401(k)? If so, then in most cases, you are well advised to contribute enough to the 401(k) to get the employers contribution (i.e., invest).

Psychological Considerations of Paying off Student Loans Versus Investing

There are non-monetary factors to consider as well. Are you one who abhors debt and will always feel uneasy with student loan debt? Or, are you risk averse and ill-suited to watch your investment value go up and down?  If either circumstance applies, then you may want to pay off the student loans to be free of the debt.

On the other hand, if you’re comfortable watching your investment portfolio value go up and down, and interested in maximizing your potential financial gain (age plays a huge factor in this), then investing while paying off the debt may be a better alternative if the interest rate on the loans is lower than the projected investment returns.

The Choice is Yours

So, do you pay off your loans or invest? In most cases, it’s a good idea to do both.

The earlier you start saving for retirement, the more time your money will have to grow and compound, and the easier it is to build up a substantial nest egg. Unless the student loan debt is ruining your psychological life and you are willing to put most other financial priorities on hold, then it’s preferable to take a more balanced approach.