Should You Pay Off Student Loans or Save Money?
Deciding between saving or paying off student loans can be tricky. This article will help you choose between your options.
If you have student loan debt, you might assume that paying off the balance should be your top priority. But like many things in the world of personal finance, what seems like a no-brainer is actually a little more complicated.
Depending on your specific priorities and circumstances, you might be better off paying the minimum each month and putting any extra money towards your savings and investing goals. We'll explain when that makes the most sense, and when you might just want to focus on becoming debt-free.
Pros of Keeping Your Student Loans
- Can save more for other goals
- Can invest money in the stock market
- Can deduct student loan interest on your taxes
- Will still be eligible for loan forgiveness
Cons of Keeping Your Student Loans
- Can add more financial stress and anxiety
- Could pay thousands in interest
- Will impact your debt-to-income ratio
Save an Emergency Fund First
Almost every financial expert will recommend saving an emergency fund before contributing extra money to your student loans. If you don’t set up a rainy day fund and need to pay for a surprise expense, like a trip to the ER or a flight to a family funeral, you may end up relying on high-interest credit cards to cover the costs - and since the average credit card APR is about 15%, you could end up paying hundreds in interest while you repay the balance.
An emergency fund should have between three to six months of living expenses, depending on your job stability, other sources of income and current expenses. If you have a mortgage or a child, err on the side of caution and save more. Consumers who are in a volatile industry may want to save more than six months of expenses.
Take Advantage of Matching 401(k) Contributions
If your employer matches contributions to your 401(k), take advantage of that instead of putting extra toward your student loan balance. Matching 401(k) contributions are essentially free money, and you should always stash enough to max out your matching contribution.
For example, let’s say your company matches 50% of your contributions, up to 3% total of your gross salary. In this example, if you contribute 6% of your income toward your 401(k), your company will contribute 3% to the account. If you earn $100,000 a year and contribute enough to get the 3% match, you’ll get $3,000 in matching contributions.
Invest for Retirement
Over the past 100 years, the S&P 500, the benchmark for the US stock market, has returned about 10% on average each year before inflation. Money that is invested in the stock market will usually outearn money that goes toward your student loans.
Here’s an example. Let’s say you owe $30,000 in student loans with a 5% interest rate. You have $100 extra that you can either put toward your student loans or invest in your retirement account. If you choose your student loans, you’ll save $2,295 in interest. If you invested the $100 instead, you would have $66,607 more in your retirement account.
Should I Pay Off Student Loans to Qualify for a House?
Some borrowers think reducing their student loan balance will improve their ability to qualify for a mortgage. In reality, lenders care more about your monthly payment than your total debt balance.
Mortgage lenders use your debt-to-income ratio (DTI) to determine the maximum monthly mortgage payment you can afford. The higher your current DTI, the lower mortgage amount you’ll qualify for.
Whether you owe $15,000 or $25,000, your DTI will remain the same. To lower your DTI, you can refinance your loans to get a lower monthly payment.
Should I Pay off Student Loans or Save for a Down Payment?
Waiting to buy a house until you pay off your student loans is a personal decision, and the right choice will depend on your income, other debts and overall financial priorities. CFP Brent Perry of Piedmont Financial Advisors said if your student loans have a high interest rate, generally 6% or more, you should split extra funds between savings and debt payoff. But it largely boils down to what matters most to you - being debt free or owning a home.
“Not every decision needs to be optimized to pay the lowest cost,” Perry said. “There is a life to be lived.”
Buy a house because you’re ready to be a homeowner, not because you think it’s the right step to take or because you want to cash in on rising housing prices. It usually takes at least five years to recoup the initial costs of buying a house. If you plan to move cities in the next couple of years, keep renting.
Before buying a house, go through your budget and compare your current expenses to your take-home pay. See if there’s a budget surplus or a deficit. You’ll need to account for not only your mortgage payments, but also the cost of repairs and maintenance.
You should always save between 1% and 3% of your home’s purchase price annually for repairs and maintenance. For example, if you buy a $200,000 home, stash away between $2,000 and $6,000 a year.
Refinance Your Student Loans
If you have student loans with high interest rates, you can refinance them for a lower rate. Refinancing can reduce the total interest paid over the life of the loan. Let’s say you owe $40,000 in student loans with an 11% interest rate and a 10-year term. If you refinance to a 5% interest rate and a 10-year term, you’ll save $15,209 in total interest and reduce your monthly payment by $127.
If you refinance to a lower interest rate and keep the same repayment term you had before, your monthly payment will decrease. You can apply the difference to your savings goals, like buying a house, going on vacation or paying for a wedding.
Also, when you refinance to a lower monthly payment, your debt-to-income ratio will drop. This will make it easier to be approved for a mortgage, along with increasing the mortgage amount you qualify for.
Borrowers can refinance federal student loans, but they’ll be giving up all the associated benefits like income-driven repayment, loan forgiveness and longer deferment and forbearance periods. There’s no way to undo refinancing, so borrowers should think carefully before refinancing federal loans. There are no downsides to refinancing private student loans, as private loans have fewer benefits.
Juno can help you to find a student loan or refinance a loan at the most competitive possible rate. We get groups of buyers together and negotiate on their behalf with lenders to save them money on private student loans and private student loan refinance loans.
Zina Kumok is a freelance writer specializing in personal finance. A former reporter, she has covered murder trials, the Final Four and everything in between. She has been featured in Lifehacker, DailyWorth and Time. Read about how she paid off $28,000 worth of student loans in three years at Conscious Coins.
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