Read this if you want to know for yourself whether it’s smarter to invest your extra money or pay down your student loans each month. Estimated read time 7 min.

What’s the dilemma?

Investing, it’s a long term fiscally wise thing to do. Over time investments provide a rate of return around 6-7%. For the sake of our discussion we’re going settle on 7%. That means you can get a rate of return at least the same as all available federal student loan interest rates (7% is the Direct PLUS interest rate and is the highest federal interest rate). This rate of return compounds on itself year after year and will continue to grow even if you stop making contributions.

The best investors have enough money invested to live off the compounding interest, and continue to invest dividends indefinitely. Yep that’s right you can invest enough money that you can withdraw money each month without actually losing anything from your originally invested amount.

Indefinite compounding interest sounds awesome and all but what are borrowers to do when we have mountains of student loan debt holding us back from financial freedom?

How can we pay for our current existence without robbing our future?

 

Today’s post highlights the results of an objective calculation that identifies the repayment strategy leading to the most growth in net worth. Spoiler Alert it’s not what common wisdom would suggest.

Assumptions.

First we’re going to discuss the assumptions that today’s formula makes. Market rates of return are variable and perform better or worse depending on the year. This formula assumes a 7% constant rate of return from the market which reflects average market performance. Recognizing some years may have stronger performance like in 2017 when I got a 13.5% rate of return from my 401K or 2015 when I had -0.57% rate of return.

This borrower is able to contribute enough money to get the full match from their employer-sponsored retirement plan no matter what repayment strategy they choose. This example is not about choosing to invest or pay down debt exclusively. It’s about deciding how extra monthly income on top of usual debt repayment and investing performs when used to pay down debt or invest.

Another important assumption made is that once you pay off your student loan debt you invest all the money you were spending to repay that debt. If you pay off your debt and funnel that money to anything other than investing this formula doesn’t hold up.

A $19,000 loss from investing.

Common wisdom goes like this. If your student loan interest rate is lower than the rate of return you expect to get from the market invest your extra income instead of making extra payments on your debt. Well here’s the thing, that math doesn’t add up. Seriously. Common wisdom is flawed. Let me lay out the scenario for you.

Sallie Jones has $100,000 of student loan debt and makes $100,000 per year. Her current student loans have an average interest rate of 6.2%. Even under the most aggressive repayment strategy she can afford to contribute $5,000 per year to her employer-sponsored 401K which earns her a $4,000 match. The market rate of return is 7% and for the sake of simplicity it compounds monthly.

Let’s compare an aggressive 5 year repayment strategy, a 10 year repayment strategy, and an income-based repayment strategy that takes 11.36 years. Each strategy assumes that she invests the money she would have been paying toward her debt.

The 5 year repayment strategy:

Increase in net worth after 11.36 years (invested value – interest): $327,103

The 10 year repayment strategy:

Increase in net worth after 11.36 years (invested value – interest): $312,924

The income-based repayment strategy:

Increase in net worth after 11.36 years (invested value – interest): $308,601

Despite the fact the student loan interest rate in this example was less than the market rate of return,

the borrower who invested the money created by a less stringent repayment plan had a net worth $19,000 less than the most aggressive repayer after 11.36 years.

Key takeaways.

-There is no “one size fits all” strategy for debt repayment or investing. You need to customize your repayment and investing strategy to your personal financial goals and specific debt and income situation.

-Choosing to follow common wisdom instead of exploring your options can cost you tens of thousands of dollars.

-This formula doesn’t take into account your non-financial goals and your attitude toward debt and investing. If you make the calculation and find one strategy has the slight edge on the other but you don’t want to take that strategy then don’t. This isn’t about getting everyone to conform to a certain standard, it’s about making sure everyone has the best information available to make decisions.

 

Will your net worth grow more if you invest more or repay your debt faster?

I designed a simple workbook that walks you through this exact calculation. In less than 10 minutes you can have a set of numbers to guide your decision-making. You can get Repayable’s Custom Guide to Investing Extra vs Repaying Aggressively.

Don’t be overwhelmed, it may seem daunting but it’s a lot of plug and play where you use your actual financial information in an online calculator rather than crunching the numbers yourself. End the debate about where to put your extra monthly income. The guide is available for download here it only requires your email address.