Student Loans

Millennials: Pay Off Student Loans or Save for Retirement?

Pay off student loans or save for retirement?

It’s a question many people in their late 20s and early 30s are facing these days. They are reminded regularly about the importance of starting to prepare for retirement early in their careers, and yet, no generation has entered the workplace with as heavy a burden of student loans. So which should come first – save for retirement or pay off student loans?

A generation ago, financial planners would likely have advised taking your time to pay off debt in favor of putting as much money as possible to work in the financial markets. The logic was that investment returns were likely to exceed the cost of carrying debt a little longer. However, this trade-off looks somewhat different today.

A Low-Return Environment

A factor that weighs heavily in the decision of whether to save for retirement or pay off student loans is that financial markets seem mired in a low-return environment. This decreases the odds that the returns you earn by investing for retirement will exceed the money you would save by paying down your student loans early.

Take the stock market for example. Over the last 10 years, the S&P 500 has risen by an average of just 4.75 percent a year. Even throwing in a little on top of that for dividends, that still does not create much of an edge over the cost of debt. The scary part is that over that same decade, operating earnings have grown by just 1.45 percent, indicating that even that modest price growth has not been supported by a fundamental increase in value. This suggests that unless earnings growth picks up considerably, investment returns could be even lower going forward.

As for bonds, at the end of September yields on U.S. Treasuries ranged anywhere from 0.20 percent to 2.32 percent. Even yields on corporate bonds have been squeezed down to offer relatively little extra reward for their extra risk. Translation: don’t expect bonds to add much extra oomph to a portfolio these days.

Holding onto debt longer in favor of getting more money invested may have made sense in the 1990s, when stocks were regularly earning double-digit returns and bond yields were more than twice as high. Today though, not so much….

Mitigating Factors

A low-return environment suggests that these days you might get more bang for your buck by paying down debt than by saving for retirement. However, there are a couple of factors that might give more of an edge to retirement saving:

  1. Tax benefit. Savings into qualified retirement accounts often are pre-tax, meaning that for every dollar you earn you can put more into a retirement account than you could use to pay off student loans after tax. However, it is important to remember that retirement account contributions are only tax-deferred, not tax-exempt. That means that you will eventually have to pay tax on that money when you withdraw it from your retirement account.
  2. Matching contributions. Some employers will match a portion of your contributions to retirement accounts, like a 401k. If your employer does this, that is a hard benefit to pass up because it instantly magnifies the impact of your retirement saving. If your employer does offer matching contributions, you might want to invest enough to maximize the amount of matching available rather than use that money to make extra student loan payments.

If after weighing the pros and cons you come down on the side of paying off student loan debt early, make those extra payments a part of your budget you can eventually devote to retirement saving. In this way, paying off student loan debt will help set the stage for retirement savings by giving you the budget discipline to put some extra money aside every month.

That way, even in today’s low-return environment, you can find a way to both pay off your student loans and start preparing for retirement.