You recently completed grad school, and landed your first big, professional job. Congratulations! Now it’s time to make some sophisticated money decisions. One of the first things you’ll need to determine is how to divvy up your new earnings between saving for retirement and paying off student loans. Which one should you prioritize?
As a general rule of thumb, if your student loan APR (or any loan for that matter) is five percent or more, you should prioritize paying it down over investing, according to some investing experts. If your APR is less than five percent, you should prioritize saving money and investing. Saving and investing are particularly prudent if your student loan interest payments are tax deductible and/or you can lower your income taxes by using tax-advantaged accounts such as a 401(k).
Let’s walk through how this might work in practice for a young professional.
Case Study: Sarah, 28, MBA
Sarah just completed business school and started a new job in San Francisco as a marketing manager. Her annual salary is $100,000, which is the 2015 median starting salary for new MBA graduates. She also has $100,000 in both private and federal student loans, and these loans have an average APR of 7.5 percent over a 10-year term.
After taxes and her 401(k) contribution of 10 percent of her salary (assuming her employer provides no matching contribution), her monthly take-home pay is about $4,600. Including her current student loan payment of $1,187, her monthly expenses are $4,500 including rent, food, and other necessities.
While Sarah is doing a great job saving in her 401(k) at work, she has very little other savings. Is saving 10 percent for retirement while paying the minimum due on her current loan the most prudent option for her?
Here are a few things Sarah might do differently to get more mileage out of paying her debt and saving for retirement:
Find extra savings with a lower APR. With her new job and secure salary, Sarah is well-positioned to refinance her student loan debt. She has a great track record of responsible money management, and is able to refinance her current student loans at 7.5 percent APR down to 4.7 percent APR. This move would reduce her monthly payment from $1,187 to $1,046 for a 10-year loan, for a savings of $141 per month, or $1,692 annually.
If she refinances with a company like Earnest, she can use the Precision Pricing feature to customize her payments to fit her budget and savings goals. She could examine several different scenarios and how they would work with her budget.
Consider extending the term. If Sarah reduced her student loan budget to $800 per month and extended her term to 14 years and nine months with 5.1 percent APR, she could save even more for retirement — or invest for other goals — on a monthly basis. That payment would net her a total savings of $387 per month from her original loan payments, or $4,644 annually. The total interest paid on her loan would be almost $43,000.
Reduce the 401(k) savings. If Sarah increased her student loan budget to $1,650 per month, she could pay off her student loans in about five years and 10 months at an APR of 4.3 percent. This option would, however, require her to reduce her 401(k) savings rate from 10 percent to four percent to increase her monthly cash flow to $5,100 in monthly income in order to afford that payment. The total interest paid on her loan would be approximately $12,944.
In Sarah’s scenarios, she can afford to prioritize savings, but she would first need to determine how much she wants to save. Every level of income has different tradeoffs. If you want to see how your own numbers stack up, experiment with both paycheck and retirement calculators.
Take a Long View of Retirement Savings
Now, let’s fast-forward to when Sarah is 67 years old and retiring from her career in business. What’s the long-term outcome of these various scenarios? By saving 10 percent of her salary earlier in her career, she earned significantly more in returns in her 401(k) — that’s how powerful compound interest is for people in their 20s.
Let’s do a quick back-of-the-napkin calculation. At a savings rate of 10 percent of her $100,000 salary in her 401(k) from ages 28 to 67, she could have put away $2.5 million in her 401(k) by age 67, with an average return of seven percent. If she opted to save only four percent of her $100,000 salary for the first six years (while aggressively paying off her debt), and then bumped up her 401(k) savings to 10 percent at age 34, she could have around $1.7 million at age 67 with the same return. (Note: Let’s assume she had annual raises of two percent and saved continuously for 39 years.)
By refinancing and/or pushing out the terms of a low-APR student loan, Sarah was able to save more for retirement over the longer term — she also had money to build an emergency savings fund (equivalent to three to six months of expenses) and even start saving for a down payment on a home.
On the other hand, by pursuing the aggressive payment plan, she’ll have to wait until she’s 34 to start saving more for retirement as well as other goals. While she’ll have the means to save much more after her loan payments are finished — including about $30,000 in saved interest — she will also need the financial discipline to play catch-up and will have lost key time in the market.
Balance Your Priorities
To be sure, there’s no one right answer that fits every person. Paying off your student loans sooner has an intangible reward that goes beyond economics: Psychologically, it can be freeing to no longer have monthly student loan payments, and it can allow you to do things like buy a house or save money for a growing family.
Every individual with student loans should weigh the combination of personal savings goals, income, financial discipline, projected earnings, and other factors to find the right balance. But no matter what, look for ways to increase savings in your budget early in your career. That’s your money on the table: Use it wisely.
Catherine New is a member of the DailyWorth Connect program. Read more about the program here.