Here are a couple of recently updated statistics:
- There is roughly $1 trillion in total outstanding student loan debt in the United States today (Consumer Finance Protection Bureau)
- There are approximately 37 million student loan borrowers with outstanding student loans (Federal Reserve Board of New York).
In my experience, when it comes to young professionals, student loans are one of the main contributors to their financial stress. For this reason, mistakes are made in crucial financial decisions. Take this seemingly simple question, “Should I pay off my student loans or save/invest?” There are major ramifications to this decision, and it comes down to the age-old dichotomy between current and future-self.
First, let me say that this post is directed specifically toward debt that is for an appreciating asset (such as education, mortgages, business loans, etc.), the interest rate is below 7% annually, and might have favorable tax treatment.
Lastly, I acknowledge the stress of carrying debt. It is natural to feel crushed or smothered by it. The process I am going to describe will probably require a paradigm shift - try to view your loans as a past investment you made in yourself. It is an investment, which hopefully has or will pay off. This is nothing more than an obligation to pay for an already successful investment.
For simplicity, I have boiled down the answer into a base followed by steps.
Begin by making the minimum payments to your student loans; be properly insured (not overly insured); pay the rest of your bills; and with the surplus, set your priorities as follows, ensuring to complete each step before the other.
- Contribute enough to your 401(k) type plan to take full advantage of your employer’s matching funds.
- Get out of debt, such as credit cards, which is above 7% annual interest.
- Build your emergency fund.
- Save/invest the remaining amount needed to fund your retirement.
- Now it comes to personal decisions. You could save for your children’s education, a home, vacations, or you could start to pay more of your student debt.
The order in which you pay your loans matters as well. After paying the minimum payments and you are attacking step number five, pay the highest interest rate loans first then move on to the next. This will create a snowball-like effect on your payments. Also, consider consolidating your loans. Usually, this can be done with no added cost through the U.S. Department of Education. http://www.loanconsolidation.ed.gov/
Is it really that simple? Doesn't the decision depend on interest rates, taxes and investment returns? This comes down to those things as much as it does how you feel about debt. Do not fool yourself, this process is the best way for most. “I feel crushed by debt, I think I am going to just pay it off” is where we start to make the largest mistake. Don’t underestimate the power of compounding interest (time-value of money) and let the fear to try a better approach get the best of you. This is a classic example of how we as humans have a tendency to concentrate on current-self but forget to take care of future-self. We put too much emphasis on how it feels to carry these loans, and too little emphasis on the importance of taking care of future you. No one else is going to take care of your future-self…will you?