In this week’s case study, the “Money Talks” hosts take a look at one of the most common questions we come across: deciding whether to pay off debt early or save for future financial goals. Specifically, the wife is still a student with plans to attend graduate school, while the husband is a teacher. He currently does not have access to an employer-sponsored retirement plan. They have around $20,000 in student loans at 6% interest. They can afford to pay an extra $100 a month toward the loan.
Paying the minimum payment on the loan requires approximately an 11.5 year payoff period. By paying an extra $100 a month, they can lower their repayment period down to 6.75 years. The interest savings from paying the loan off earlier would be about $3,400.
Many consumer finance advisers will recommend paying down debt, because a 6% interest rate is a significant enough interest rate to require careful consideration. From a pure financial standpoint, the decision can be determined by whether or not an investment can outperform the rate of interest on the loan. If yes, they may want to pay the minimum due each month and invest the difference. If an investment cannot outperform the 6% interest rate on the loan, they should use excess income to pay down the loan principal.
However, in practice, there are many more factors to consider other than performance. They need to consider their time horizon for their investment, and match their liabilities with appropriate assets. If the extra income is intended for a down payment in the next five years, they may want to be more conservative in their investments to protect principal. With a low interest rate environment, conservative investments are generally earning less than 6%. If the extra income is intended for retirement savings, which for them is more than 30 years away, they can afford to invest more aggressively. The stock market’s average long-term return is near 10%. They also need to consider other risks, such as interest rate risk, and purchasing power risk, income stability, personal comfort level with carrying debt and tax factors, as up to $2,500 of student loan interest paid can be tax deductible. It is also important to note that student loans are generally not discharged in bankruptcy, as the requirements for loan forgiveness are stringent.
Let’s assume the couple can earn 7% annually on their investment over the 6.75 years they would otherwise be paying the $100 toward loan principal. After 6.75 years, a $100 per month investment would have grown to about $10,300. However, the loan balance would still be approximately $10,000, so you would have made a better choice to invest the money, but only by a small margin. The larger the gap between the interest rate and the expected investment return, the better off they should be to invest the money; however, this choice comes with a substantial amount of risk.
Putting $100 a month into a Roth IRA could provide the couple with tax-free growth of the investment over their lifetime. While they would not have any tax benefit for contributing, distributions are tax-free provided five years has elapsed since the initial contribution and the distribution is due to attainment of age 59 ½, death or disability or for a first home purchase. A Roth IRA investment can be liquid, earn a return and offer flexibility.
When you are first starting out in your career, cash flow is everything. The couple does have a family dynamic to consider. In theory, it is easy to say you will save the $100 each month, but in practice it is much harder not to use it for daily expenses. If they would be happy to earn a 6% “return”—which is a known variable—we recommend paying down the loan. Once the loan is paid off they can then invest the loan payment of $300 per month over a longer period of time.
If you have questions on balancing your debt and savings, experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
