Why you might not want to pay off all your student loans before investing

Let’s pretend that you’ve just graduated college with a shiny new degree and a big ol’ bag of debt! Should you focus on paying off your loans first and THEN start investing? Or should you follow the standard payoff schedule and invest at the same time?

Unfortunately for you, everyone has an opinion but nobody takes the time to actually run the numbers. 

(sigh) Fine, I’ll do it! Sit back and relax while I do all the heavy lifting for you and the rest of Twitter’s lazy evangelists.

In today’s “Story By Numbers” I will walk you through the tale of a young physical therapist who graduated school with $60,000 of student loans. She went to work right away, earning $80,000 her first year with a guaranteed (but modest) 3% raise every year. Her company offers a 401(k) with a small match but some random person on the internet told her not to contribute to it until all her debt has been paid off.

What ever should she do? (Answer: math. She should do the math.)

Graduation: the transition from spending to making money

Our heroine realizes that she need not focus on just her debt or just her account balance but her total net worth. Even more impressive, she realizes that the wealth building game is a marathon, so she figures the best way to compare the two strategies (pay off debt vs invest) is to compare her total net worth at the end of 30 years.

To simplify this comparison she correctly assumes that her entire net worth in life will be her 401(k) balance minus her debt balance at the end of 30 years. Her debt balance will be $0 by then, so whichever strategy provides the highest 401(k) balance at the end of 30 years wins.

Place your bets now – which do you think is the better strategy?

First, some assumptions:

For the sake of fairness and consistency, our physical therapist super-saver has also decided that any cash previously being used to pay off her loans would go toward her 401(k) savings once the debt is paid off (you can see this below under the column “401(k) Extra”).

The (Hypothetical) Results

And there you have it! Paying off her debt over the standard 10 year schedule while simultaneously contributing to her 401(k) yields our physical therapist friend a higher total net worth at the end of 30 years under these conditions.

Some Common Objections

What If The Stock Market Crashes?

That’s a pretty weak argument. It is akin to market timing which we all know is a losing strategy. I could just as easily counter by saying, “What if we have a blowout bull market during the heroine’s early years of saving?” Such a scenario is actually more likely to happen and would further support one’s decision to start investing right away.

Paying Off The Debt Is Guaranteed But Stock Market Returns Are Not

True but this argument depends heavily on (1) the interest being charged and (2) the expected returns. Higher interest charged and lower expected returns will tip the scales in favor of paying off the debt but the opposite is surely true as well. And remember, in this example we used the WORST 20 year performance in history and an extremely high 6.5% interest rate on the loans. This scenario was built to favor paying off the loans first yet Scenario #2 STILL won the race!

But My Employer Does Not Offer Matching

Let’s say you have access to a SEP or SIMPLE IRA but no 401(k) with match. If we remove the match completely from our calculation then Scenario #1 actually only catches up to #2.

So What Should I Do?

That’s easy. Get off the internet and run these same numbers with assumptions that work for your specific scenario. Don’t feel comfortable running the numbers yourself? Find somebody who you trust to steer you in the right direction and ask them for help. But under no condition should you stick your head in the sand and hope all this math stuff will go away, it won’t.