Retirement Savings versus Student Loans

By Pinyo, on August 19, 2008

Prioritizing retirement savings against paying down student loans is a very common money management question for young workers today. This wasn’t the case in prior generations where college graduates start their first job with less student loans and were offered pension as part of their benefits package.

Yin Yang

Photo by Grisei via Flickr

When I started out, I worked as a contract worker so there wasn’t a retirement savings plan aside from the $2,000 contribution to my IRA. As such, it was an easy decision for me. I focused all my energy on paying down debt — my student loans, car loan, and credit card debt were gone in less than a year. It would be a lot different if I just graduated recently and work full-time somewhere. I would have to decide where to put my money: (A) 401k with $15,500 limit, (2) IRA with $5,000 limit, or (3) student loans and other debt.

If You Owe More Than Just The Student Loans

Student loans usually have lower interest rates, and you could take advantage of student loans consolidation program to make the loan repayment more advantageous for you. However, if you owe other types of debt — specifically, credit card debt — I would personally do everything I could to exterminate them first.

Here’s a 7 steps debt reduction technique that you could use.

Retirement Savings First

If all you have is your student loans, the answer might be to put your money toward retirement savings first. Particularly, if your employer provides 401k match, you should try to contribute enough money to your 401k to maximize the matching contribution. Depending on the set up, we are talking about 50-100% instant return on investment.

There’s a huge advantage in starting your retirement savings as early as possible — your savings could be nearly 3 times more by starting at 25 versus at 35 (see the illustration below):

Decade difference

While you are putting money away toward retirement, just keep paying the minimum required amount on your student loans and be sure not to accumulate any new debt.

It’s All About Math

Aside from the two exceptions above, the answer is really all about math. If the interest rates on your student loans are high relative to the expected rate of return on your investment, paying the loans off as fast as possible might be your best bet. Remember that you can also deduct up to $2,500 in student loan interest even if you don’t itemize deductions on your income tax return. So be sure to factor this into your calculation.

However, if your interest rates are low, it might be better to get the ball rolling on your retirement investing. Again, I feel very strongly about starting your retirement investing as soon as possible.

In the end, there are a lot of factors at play and you’ll have to decide both mathematically and psychologically the right thing for you to do. To explore this subject further, here are a few articles written by other bloggers:

Why I’m not paying off my student loans early at Plonkee Money
Retirement Savings Or Debt Repayment: Which Is More Important? at The Simple Dollar
Real-Life Choices: Retirement Savings vs. Debt Reduction at Get Rich Slowly
How to Pay Off Student Loans While Building Wealth at Free Money Finance

This article was featured in the Carnival of Debt Reduction hosted at Carnival of Debt Reduction

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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7 Comments

James
August 19, 2008, 9:46

This is good advice. I used to believe that the goal was to get out of debt as fast as you can at all costs, THEN start saving for retirement, but that really takes a short-term approach to your finances. It’s more emotional than logical and while it has it’s benefits, in the long-term, you will have less money. Thanks for the article.
MoneyGrubbingLawyer
August 19, 2008, 14:31

Pinyo, I agree with this approach — it’s the most efficient way to manage your finances.

However, when it comes to choosing between paying down student debt, contributing to retirement savings, and establishing an emergency fund, the emergency fund wins out. It’s important to have a good contingency fund in place before you start allocating your money. Most student loans are not readvanceable and retirement savings are not always easily accessible — you want to make sure that you can meet your obligations and provide for your needs in the event of an emergency or sudden job loss.
Pinyo
August 19, 2008, 15:05

@James — Exactly and you’re welcome.

@MoneyGrubbing — While I agree that there should be some emergency fund, I don’t think it should be a large amount like 3-6 months that most experts recommend. Young people are a lot more resilient and flexible to deal with financial emergencies (they are not heavily burdened like older adults), so they should be more willing to take calculated risk to get rid of their debt and start off their retirement savings.
Sara - pension comparison
August 20, 2008, 15:56

Once you start earning a salary, set aside a percentage of your salary to pay back your student loans. When your loan is paid off, invest that same percentage into your retirement fund. You won’t miss what you never had.
marci
August 24, 2008, 14:16

I be starting my retirement acct so it could grow on it’s own. Once I had a small amount tucked away to grow, then I’d be throwing everything, except what was needed for the matching funds on the 401K for example, onto the student loan debts.
Shuchong
August 24, 2008, 17:46

I’ve also heard a strategy that makes a lot of sense to me – treat your student loans as a bond of sorts. After all, they’re a debt instrument, just like bonds are, and they “earn” a fixed percentage in that by paying them off, you’ll avoid paying certain percentage of interest. So, for example, if your bond fund had a yield of 4.3% but you were paying 7% on your student loans, it would probably make sense to put money towards your loans instead of towards a bond fund (I’m ignoring tax issues here, but of course you would want to calculate tax-equivalent yields for both options and see which is actually a better deal).

Then, when you calculate your asset allocation, treat the student loans as a bond.

Then have two different options for bringing your portfolio back to your desired asset allocation – you can either buy more stocks to reduce your bond percentage, or you can pre-pay your loan. Your choices can be based on expected equity returns, need for liquidity (you can sell stocks, but you probably can’t get money back out of your student loan once you’ve put it in) etc. Some people might also consider holding a little bit in a bond fund because of the rebalancing opportunities it presents.
Pinyo
August 26, 2008, 0:01

@Sara — That would be a good strategy for some people.

@Marci — That sounds like a plan. Good luck.

@Shuchong — Good article on your blog: http://butwhydoesnt.blogspot.c.....nt-vs.html. I left a comment.

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