“The longest journey begins with a single step” –Laozi (580 BCE)
Investing is a long-term game. As that really smart Chinese philosopher said, that long-term game needs to start with your first move. For most people, investing will start when they get their first “adult” job after college (you already know how I feel about college).
Some people start with a clean financial slate when they leave college, but many have student debt from all the loans they took for that degree. That sets up an interesting question as they get their first paychecks: what to do with the money? You can even make the question more precise and ask: should I use my savings to payoff my student loans or start investing? Let’s dive right in
My niece Starty Fox just graduated with her engineering degree from State U. She has $20,000 in student loans that has an interest rate of 4.45% (I think that’s the current rate for government backed student loans). Because she listened to her wise uncle, she got an engineering degree which presents many job opportunities. She took a good job paying $54,000 per year (luckily her salary is divisible by 12 so this post is a little easier to write). Plus, they offer a 401k which matches her contributions up to 6% of her salary.
After she accounts for rent (her parents made it clear she could visit, but not live with them), her car payment, food, and other living expenses she is able to save 10% of her income each month. She makes $4,500 per month and has $450 left over at the end of each month (let’s ignore taxes for a second, but just a second).
So what should she do, payoff that nagging student debt as fast as she can or start investing in her company’s 401k?
A match lights the world on fire
Let’s say Starty has a neurosis about her debt. She was raised never to have any debt (although maybe that’s not always the best idea—here and here), so she wants to pay it off as quickly as she can.
If she applied all $450 each month to her student loans, she would pay off that whole $20,000 in a little over 5 years. There would be a couple things she wouldn’t like. First, that $450 would be taxed (just like the rest of her income). Let’s say her marginal tax rate is 20%, so that means the $450 she has set aside is really only $360 after she pays Uncle Sam. Taxes are unavoidable, so while that’s a bummer for Starty, she accepts it as a fact of life (although maybe she shouldn’t—more on that in a second).
When it is all said and done, she will have paid everything off by the time she turns 27, which isn’t bad. Through it all she would have paid about $2,300 in interest. That interest is tax deductible, so it would only feel like about $1,840. After everything is paid off, she can start investing in her 401k with a clear conscious.
Let’s take the other extreme, and assume that Starty watched Wall Street a lot with her adoring uncle when she was little. She’s not too concerned about debt, especially when there are other good investment opportunities out there. She pays her minimum payment on her loan ($150 per month before taxes, $120 after taxes) and then invests the rest in her 401k.
Obviously, the downside of this is it takes her a lot longer to pay off her loan; instead of being done by age 27, she’ll have the debt until she’s 40. That sucks. But she more than makes up for that with her 401k. Every year she contributes $3,600 to her 401k. When she does this she has three really big spoonfuls of awesomeness working for her:
- Tax free—her 401k contributions are pre-tax so just off the top she is saving $30 per month that would go to taxes if she used that money to pay off her loan. That’s enough to buy a new Lululemon outfit and splurge on extra spin classes each year (Foxy Lady just took over my computer for a second). Sure, eventually she’ll have to pay that in taxes, but there are a lot of things she can do to minimize that when the time comes.
- Match—the big one is that Starty gets to take advantage of her company’s match. They match dollar-for-dollar up to 6% of her salary. Since she’s contributing more than that, she takes complete advantage of the match, and that comes to $270 each month.
- Investment returns—obviously this is why we do invest money. On average Starty is going to earn a 6-8% return on her 401k.
If you put that all into the pot and mix it, you’d have a 27-year-old Starty who is debt-free but with nothing in her 401k, or you could have a 27-year-old with $41,000 in her 401k and still with $16,000 in student loans. Obviously, the 401k option is much better. She has a net worth of $25,000 on her 27th birthday (versus $0 if she paid off her student loans first).
The cause of it all
Those numbers tell a pretty powerful story that from a mathematical point of view, paying off your student loan at the lowest level is best so long as you put that money into your 401k (and not spend it on stupid crap). However, there are some fairly big assumptions there.
Match—obviously the match is a big part of it all. Without the match the numbers don’t look nearly as good, but the 401k option still comes out ahead. On her 27th birthday, she would have a net worth of $5,500, without the match. Many people may complain that this example isn’t realistic because Starty’s 401k match is so generous, but without the match she still comes out to the good. And we know a 401k without a match is basically like a traditional IRA which is available to everyone.
Liquidity—when Starty chooses to go all in on her 401k she’s losing a lot of financial flexibility. At 27 she’ll still have $15,000 of debt that she’ll have to pay off plus she’ll have a lot of her money tied up in her 401k which is very hard to access. If something happened at ages 22-27 she’d be in pretty much the same boat either way, but after age 27 she’d have a little more flexibility if she had killed the college debt. This becomes a question very similar to the one we raised with the post on the emergency fund. Personally, I would be willing to roll the dice for that extra $5-25k over five years, but risk aversion is different for all of us.
That’s all good, but fundamentally this boils down to Starty being able to borrow money at 4.45% (3.6% after taxes) and being able to invest it at a higher rate, 7% for argument’s sake. Over a 20 year time horizon (about how long it takes her to pay off her student loan), stocks have historically done much better than that 4% hurdle. For all these reasons, it does make a lot of sense—in Starty’s case thousands of dollars each year—to slowly pay off her college debt and put that money into her 401k.