Over the weekend I spoke to a friend who graduated from physical therapy school earlier this year. He didn’t have any help with school expenses and graduated with $160,000 in student loans. To his benefit, he’s pretty frugal and has a good natural sense about money. However, $160,000 is a really big number and it has him worried. He’s been asking himself if he’s going to be able to be okay with that amount of debt and whether the right decision is to pay down the debt as quickly as possible or if he should save for retirement as well.
To answer his question, I think he’s going to be okay. He just graduated from college with a Doctor of Physical Therapy degree, has no debt outside of the loans, saves a large percentage of his income each month, and he has an emergency fund in place plus additional funds that he’s planning on putting towards student loans once forbearance is up. He’s setting himself up for success.
The debt is all Federal student loans with an interest rate of about 7%. Once he becomes eligible to participate in his employer’s 401(k), he’ll receive a 5% match. Taking the match is a no brainer since it’s a 100% return on his money and he’s already accomplished the basic steps of getting an emergency fund in place and not accruing credit card debt.
The real question is whether he should contribute more to retirement accounts than just the match given the high interest rate on the student loans.
What Would Payments Look Like?
First, I think it’s important to understand what the student loan payments will look like once payments come due and how that will affect cash flow. He didn’t know what the payments would be and hasn’t contacted the student loan servicer to find out yet.
Assuming that the $160,000 of debt at 7% interest is set to be repaid on the standard 10-year student loan repayment plan, his payment would be $1,857.74 per month. That’s a pretty hefty monthly burden, even for someone of his earning potential. Extending the repayment plan to a 20-year term would decrease the monthly payment to $1,240.48.
In either scenario that’s a significant amount of cash for a new graduate to shell out each month.
Consider The Strategies
The simple answer to the question of whether to pay off the student loans aggressively or invest more for retirement is this: if the student loans have a higher interest rate than the expected rate of return of your portfolio, then you should pay down the student loans. You can also look at it the opposite way: if your expected rate of return of your retirement portfolio is higher than the interest rate on your student loans, then you should focus on investing more for retirement.
However, that’s the simple answer. There’s more nuance that typically goes into financial decision making. On one hand, it’s hard for me to argue against paying down a loan at a 7% interest rate as quickly as possible. That’s a pretty high interest rate and you’d be hard-pressed to find a financial institution that will project a portfolio rate of return of 7% or higher going forward.
On the other hand, it’s hard for me to tell someone who just graduated and has nothing saved to only invest the minimum for retirement for a significant period of time (10, 20, 30 years, or however long it takes to pay off the loans). That’s a long time to go without investing for retirement and benefitting from compounding returns.
But the strategy doesn’t have to be 100% pay down student loans or 100% save for retirement. It could be some sort of split like using 50% of extra cash flow to pay down loans and using 50% to save for retirement or 75/25 or any other combination.
Additionally, you could save extra funds to a brokerage account to invest, rather than a retirement account, since it is more flexible. That way, you could use the funds to pay down the student loans at a later date if you decided that you want to. The risk of this strategy is if you have the funds invested and the market crashes, the money may not be there to help pay down the loans when you want it to be.
Another option that came to mind could be to get the 401(k) match, max out a Roth IRA (maximum contribution of $6,000 in 2021), and use remaining cash flow for extra payments on the student loans.
(PS. My friend wasn’t aware that you can contribute to a 401(k) AND a Roth IRA at the same time (assuming your income falls within the rules for contributing to a Roth IRA). He also wasn’t aware that an employer 401(k) can include a Roth contribution option. These are both common misunderstandings, which is why I’m sharing it here.)
Things to Think About When Refinancing
One option would be to refinance his student loans to get a lower interest rate and lower payment. However, there are some downsides to refinancing his student loans – losing the benefits that the Federal loans provide.
When you refinance Federal student loans to private loans you lose the repayment plan options provided under Federal loans, you lose forgiveness options such as PSLF, you don’t benefit from forbearance such as Federal student loan borrowers have since March 2020 and will continue to do so through January 31, 2022, and if you were to pass away private student loans would not be discharged like Federal student loans are.
While it doesn’t solve the problem of losing repayment plan options and other benefits such as forbearance, getting a term life insurance policy in place could help with the risk of passing away and leaving loans for family to deal with.
If you get quotes for refinancing Federal student loans into private loans, and you like the terms of the quotes provided, then you could also get quotes for a term life insurance policy to protect your loved ones against having to pay the loans if you were to pass away. This should be relatively cheap for a healthy young professional.
There are two main options that I see in regards to life insurance in this situation. One option would be to look into a term life insurance policy that would last for the term of the loans and enough death benefit to pay them off if something were to happen.
Another option would be to think about your financial future and look into life insurance options to protect your future family. This may mean a policy with a higher death benefit and potentially longer term. A benefit of this strategy could be getting the policy in place at a time when you’re healthy and not risking becoming uninsurable if something were to happen to you in the future.
It will also be important for him to make sure that he maxes out the disability insurance benefits that his employer provides and to potentially supplement that with a private policy as well.
Opportunity Costs
But there’s always an opportunity cost. Every decision that you make is a trade off on something else. Every extra dollar that he pays towards the student loans is a dollar that he can’t invest. Likewise, every dollar that he invests can’t go towards paying down the loans.
I originally started running a bunch of numbers about what refinancing might look like and how that might affect payments and interest paid over the life of the loans and comparing that to a potential portfolio balance, but I decided to delete all of that.
I think there are too many ‘what ifs’ to accurately dive into that situation here. It would be much easier if we knew what refinancing would look like.
Pay Down Loans or Invest for Retirement?
So, should he pay down his student loans as fast as possible or invest for retirement? Unfortunately, there’s no perfect answer. It’s important to think through all of the options and come to a conclusion that you feel comfortable with and that leads to financial success.
