Invest Early or Pay Off Your Student Debt?
This is a common dilemma facing young medical professionals: You want to start your nest egg because you've been following Future Proof, MD and believe in the importance of starting your investments early (Why You Should Start Saving - Yesterday!). But you also want to pay off your six-figure student debt. How do you decide which one to tackle first? The answer can get convoluted fast. Let me take you down an easier path...
1. Do you qualify for loan forgiveness? There are a variety of loan forgiveness programs out there, the most popular one being Public Service Loan Forgiveness (PSLF). I've talked about PSLF in separate posts here and here. If the answer is yes, then you should slow your roll in paying off your student loans, at least the portion eligible for loan forgiveness.
2. What is your loan interest rate? This will affect your calculations in later steps. The standard student loan interest rate for Direct Loans is 6.8%. If you do not qualify for any loan forgiveness programs, then you are stuck with the full balance of your student debt (student loans are one of the few debts NOT dischargeable in bankruptcy). It may be worthwhile to look into student loan refinancing offers to lower your interest rate (To Be, or Not to Be...Consolidated/Refinanced...On Your Student Loans...). If you decide to refinance, use the lower interest rate for the calculations below.
3. What is your investing style? This will decide what kind of returns you can reasonably expect from starting your investments early. See my previous post Long Term Investment Returns - A Comparison for a comparison between different investment vehicles and their long term returns.
4. What's the difference between rates from step 3 and step 2 (Expected return% - Loan interest%)? If the number is 0 or negative, pay your student debt off as quickly as possible. For example, if you are a conservative investor and only plan on investing in bonds which has an annualized return of 5% over the long term and your student loan interest rate is 6.8%, every dollar you invest instead of paying off your loans is going to put you deeper in debt by 1.8%. If the number is positive, compare it with the inflation rate (currently 0.2%) to see if you will come out ahead after cost of living adjustments. If the answer is yes, then start investing early.
Case example: Medical resident A has $150,000 in student debt accruing 6.5% interest. He plans to take advantage of PSLF and has an investment risk tolerance at the same level of the S&P 500 (~10% annual return). In this case, the calculation puts him ahead at 3.5% annually which is greater than the inflation rate of 0.2%. Resident A decides to pay the minimum payment on Income Based Repayment (IBR) and put the money he would have paid under standard repayment towards investing. Sounds familiar? Surprise! Resident A is me.
Caveat: Note that the interest on your student loans is guaranteed — every dollar you pay off gets you a 6.8% return on that dollar. On the other hand, your investment returns are potential, meaning that you don't know whether you will actually make money until you are ready to cash out. We don't have to look back too far to see how much volatility investments come with — think 2008-2010. The investment returns cited in Long Term Investment Returns - A Comparison are more accurate when you take the long-term approach to investing — think decades.
I hope the above steps help you get a start in deciding whether to pay down your student debt or start investing first. Keep in mind that student loan interest return is guaranteed while investment returns are potential. If you agree/disagree with my method or have a better system, please let me know in the comments.