Sunday , 21 April 2024

Millennials: Should You Pay Off Your Student Loan Before Starting to Save For Retirement?

Should the Millennial cohort pay off their student loan before investing in the stock debtmarket as a means of saving for retirement or do a little bit of both? This article discusses the different options and comes to an interesting conclusion.

Noah Smith wrote a column for Bloomberg View last week that discussed the different options that Millennials have for their investing purposes. He laid out the two most frequently cited choices:

  1. Invest in stocks for retirement
  2. Pay off student loans

Smith makes a good case for student loans as the best way for a young person to save money:

Paying down student debt is an investment. It’s the same kind of activity as investing in stocks or bonds. If you pay down $1,000 of student debt that was costing you 7% interest, you just effectively achieved a 7% return!…so for millennials staggering under the weight of student loans, paying down those loans is likely a better bet than investing in stocks.

There’s a solid argument to be made for each side of the aisle on this one. I could go through a lengthy list of pros and cons for each, citing such factors as:

  • interest tax breaks,
  • the benefits of tax-deferred retirement accounts,
  • compound interest from saving early,
  • expected long-term returns from a diversified stock portfolio,
  • interest rate or inflation risk and
  • many other features for each choice

but people (especially Millennials) don’t make their financial decisions based on rational, mathematically based reasoning. That’s why it’s called personal finance. There are always psychological factors at play when money is involved.

Consider the debt “snowball” approach to paying off credit card balances. Researchers Gal and McShane from Northwestern looked at this debt repayment strategy which looks for small victories by paying off the smallest balance first…[and] found that consumers who pursued the “small victories” strategy were more likely to eliminate their entire debt balance saying, “closing debt accounts – independent of the dollar balances of the closed accounts – predicted successful debt elimination at any point in the debt settlement program” [but that] “perhaps consumers should be told of both the rationally optimal approach to eliminate debt — that is, paying off higher-interest balances first — as well as the possible psychological benefits of closing account balances. Consumers can then make an informed decision.”

If you run the numbers, the debt snowball approach makes no sense. In a perfect world everyone with credit card debt would simply pay down their highest interest rate balance first because it saves the most money in the long run but human behavior isn’t perfect.

Psychological wins can be huge for motivational purposes and the creation of good habits and this is why I don’t think it makes sense to run the numbers down to the last decimal point on the stocks versus student loan debate when it comes to saving for Millennials. A good balance between…[the] two is needed to develop good habits for each. That means paying down student loans and saving money for retirement all at once, even if it’s a small amount for each.

An exclusive focus on debt repayment at the expense of retirement savings is probably a bad idea for most, for the simple reason that it’s hard to prioritize saving money as you age. There will always be a good reason to put off saving for retirement until later. Most assume they will roll over their debt payments into retirement savings immediately following the payoff of the student loans. The problem with this is that life gets in the way. There will always be something new that pops up that you could put that old debt payment towards. It becomes easy to delay retirement savings until later because it’s so far out into the future.

Even saving $50-$100 a month towards retirement can help. It takes time to see results as the balance will grow slowly, but once the retirement account is set up and saving is made automatic, it’s much harder to turn it off than it is to turn it on. Incremental increases can be made over time as compound interest builds its own snowball of small victories.

A good balance between debt repayment and retirement savings will be whatever, psychologically, helps them achieve both goals and stick with them over time.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

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