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Student Loans VS. Retirement

Lisa Whitley — Have you ever read research that humans are actually pretty bad at multitasking? Instead of doing one thing well when we give it our undivided attention, we end up doing a bunch of things poorly? I am here to tell you that while this is undoubtedly true in some circumstances (driving comes to mind), it is not necessarily true when it comes to achieving personal finance goals. Recently I came across an academic journal article entitled “As Soon As…” that really resonated with me. What this team of researchers found in their research study was that almost 40 percent of survey respondents, most of whom were young adults, were putting off saving for retirement until they had accomplished another financial goal; quite often it was "paying off student loans." Yes, they’ll get around to saving for retirement...as soon as those darned loans are paid off. It all seems so responsible. You must vanquish all of your debt entirely before you even think of any other financial goal! Eat your vegetables first! But is this actually the best route? Could multitasking lead to a better overall outcome?

Let’s crunch some numbers.

Scenario 1: Assume that your monthly student loan payment is $350, which is about average these days for a person with only undergraduate school debt who is looking to pay it off in ten years. But because you are fiscally responsible, you plan to buckle down and pay an extra $150 each month and wave goodbye to that debt in less than seven years. And then you will really attack retirement savings, channeling that $500 each month to your retirement account. After three years (ten years since your graduation), your retirement account will be worth $19,650 assuming a very reasonable 7% return. Scenario 2: You make the usual $350 student loan payment for 10 years and put the extra $150 into a retirement account. It will grow to $25,452 in 10 years. Of course, you paid an extra $2,973 in loan interest during that time, so let’s call our gain $1,805 at the 10 year mark.

(By the way, I am omitting taxes here. You may be able to deduct the student loan interest depending on your income. And your retirement account may grow tax free. For today, let’s call taxes a wash, shall we?)

I don’t want to focus so much on the “gain” between the two scenarios, however. You knew without suffering through the math that the higher investment return would beat today’s lower student loan interest rate. And because our model student in Scenario #1 channeled all of their former student loan payment to savings, so that the amount invested was exactly the same at the end of 10 years, the difference in this example was actually not huge. If you did faithfully and immediately redirect all of that former student loan payment to retirement, you could possibly make up for much of the late start. But will you? In the intervening years, your life and possibly your obligations have grown. New priorities have developed that are competing for your attention...and your wallet. What I want to highlight is the most valuable asset our young graduate has, and that is time. Yes, time for returns to compound but just as importantly, time for habits to take root. Just for simplicity’s sake, let us assume that our young graduate has set a goal to have $2 million saved up for retirement 40 years from now. (That sounds like a lot. It won’t be in 40 years.) If s/he waits ten years to get started, they will need to save about $24,000 annually to meet their goal. This is $12,000 moreeach year than if they had started saving earlier. Somewhere within that extra twelve thousand dollars each year, our young adult will likely want to accommodate saving for a home down payment, starting a family, traveling or some other life goal. (You can play with these numbers yourself at investor.gov which has a plethora of fun calculators.)  But what if our friend makes the usual student loan payment for 10 years and during that time signs up for her employer’s 401(k) plan? Her starting salary is modest so at first she puts in just the minimum amount each year to get the employer’s match -- let us say 5 percent of her $40,000 salary or $2,000 -- and her employer kicks in another $2,000. (Side note: This will only “cost” about $125 out of each month’s paycheck because the contribution is withheld pre-tax.) But each year she increases her contribution a bit, by 1 percent of her salary until she is putting 14 percent of her gross income towards retirement in the tenth year. (I have assumed that her salary has grown 3% each year.) Saving modestly in these early years and steadily increasing as her salary grows, has resulted in an additional $672,041 in her final retirement account balance compared to not taking any action for ten years. If she did not save a penny more (but you know she will!), she will have amassed more than six hundred thousand dollars towards retirement. Have I convinced you yet? It’s not just about the math. Savings is a habit, or at least should be. I am one hundred percent confident in saying that a habit formed early is more likely to be kept than one that you will start...as soon as. For you, the “right” answer may be somewhere in between our scenarios...kicking in some extra on the student loan so that you can leave that debt behind earlier, while still making contributions early and often to your retirement. It’s all about finding the balance that works for you. Your finances should bring you joy. I am not talking about riches, but rather a feeling of wellness and peace. For many, that comes from being completely debt free as soon as possible. I completely get that. But for others, there is a feeling of accomplishment when you see your savings balance grow. Literally seeing your future and its possibilities unfold in your retirement account can be pretty powerful. Maybe that is you.