You have landed your first big job after graduate school and are finally making a substantial income after years of take-out dinners, cafeteria coffee, and loan deferments.
It’s time to give some real thought about how to divvy up your paycheck when it comes to balancing your student loan payments and saving for retirement. Which one should you prioritize?
It depends on the interest rate environment but as a general rule of thumb, according to some investing experts, if your loan APR is in the range of 5% or more then you should prioritize paying it down over investing.
If your APR is less than 5% then you should prioritize saving money and investing — this is particularly true if your 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 with a fictional client of ours named Allison.1
Hypothetical case study: Allison, 25, lawyer
Allison just completed law school and is starting a new job in New York City. Her annual salary is $160,000, which is near the median for first-year attorneys. She also has $100,000 in student loans, on which she’s paying an average APR of 7.5% over a 10-year term.
After taxes and her 401(k) contribution of 10% of her salary, her monthly take-home pay is $6,615. Including her current student loan payment of $1,187, her monthly expenses are $6,500 including rent, food and other expenses.
While Allison is doing a great job saving in her 401(k) at work, she has very little other savings. As she looks at her budget, she wonders if she’s doing the right thing.
Look for extra savings in your budget.
The first place Allison should look is at her loan APR — this is a place where she can start saving money immediately.
With her professional job and a solid track record of responsible money management, Allison can refinance her student loans at 7.5% APR down to 4.7% APR. That move reduces her monthly payment from $1,187 to $1,046 for a 10-year loan for savings of $141 per month — or $1,692 annually.
With Earnest’s Precision Pricing feature, she can now customize her payments to fit her budget and savings goals. She looks at a couple different scenarios.
If Allison reduced her student loan budget to $800 per month and extended her term to 14 years and nine months with 5.1% APR, she can save even more for retirement on a monthly basis. That payment nets her a total savings of $387 per month — or $4,644 annually. Her total interest paid on her loan would be almost $43,000.
If Allison increased her student loan budget to $1,850 per month, she can finish her student loans in five years and three months at an APR of 4.3% — with an important caveat. This would mean cutting her 401(k) savings rate to 4% to increase her monthly cash flow to afford that payment. Her total interest paid on her loan would be approximately $11,350.
In Allison’s scenarios, she can afford to prioritize saving — and her question is how much to save. But every level of income has different tradeoffs. If you want to see how your own numbers stack up, spend some time with a retirement calculator.
What is the impact on retirement?
Now, let’s fast forward to when Allison is 67 and retiring from her legal career. What’s the long-term outcome of these various scenarios? By saving 10% of salary earlier in her career she earned nearly $1 million more in returns in her 401(k) — that’s how powerful compound interest is for people in their 20s.2
At a savings rate of 10% of her salary in her 401(k) from ages 25 to 67, she could have $4.4 million in her 401(k) by age 67 with an average return of 7%. If she opted to save only 4% of her $160,000 salary for the first five years (while aggressively paying off her debt) and then bumped up to 10% at age 30, she should have $3.5 million at age 67 with the same return.
By refinancing and/or pushing out a low-APR student loan, Allison 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 month of expenses) and even start saving for a home down payment earlier in her life.
On the other hand, if she pursued the aggressive payment plan, she’ll have to wait until she’s 30 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 $32,000 in saved interest — she will also need the financial discipline to play catch up and has lost key time in the market.
What’s most important to you?
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.
Every individual with student loans has to weigh the combination of personal savings goals, income, financial discipline, projected earnings, and more in order to find the right balance. But no matter what, look for ways to increase savings in your budget early on in your career. That’s your money on the table. Now use it wisely.
1 The case study of Allison is intended as an example and all numbers are for the purpose of illustration. Rates used in this example are among the best possible actual rates for loans provided by Earnest.
2Using the Bankrate calculator, assumptions include: Start investing at 25 with a retirement age of 67. Both scenarios started with annual salary of $160,000 with approximate 2% annual raise and 7% returns. This calculation does not include an employer match.