My little brother just finished college this past May. As a part of his graduation gift, my parents gave him $10k for him to do with what he wants. As a guy in his early 20’s, I figured he’d start spending it, but fortunately for him, he’s a lot smarter than that. During our annual 4th of July fishing trip he asked me what he should do with the money. Should he pay down some of his debt or invest it?
The answer to this question isn’t exactly cut and dry. First of all, there are a number of variables at play: Interest rates, investment return rates, current markets, personal needs, and goals can vastly change the final decision. And while some situations do have a right and wrong answer if the question is simply “Which will make me more money in the long-run?”, there’s usually much more to the decision than that.
More about my brother’s situation:
He has some student loans (around $20k) and some minor credit card debt (under $1000). He has a part time job and he’s living from home. He currently has no 401k or investment portfolio of any kind. Fairly typical for today’s recent college grads. In fact, if anything, his student loan debt is perhaps on the low side. So, what should he do?
The first step to deciding what to do with extra income is determine what kind of returns you are going to get. Which will make my brother more money in the long-run: paying off debt or investing the money? The first step to determining ROI is calculating post-tax returns on investments and post-tax interest on debts. If after taxes, the estimated investment return rate is greater than the adjusted interest rate of loans & debt, it’s usually better to invest.
My brother’s student loan debt has a low interest rate of about 5%. But since that interest is tax deductible, it’s actually closer to 4% (after taxes). Because achieving a 4% or higher return rate is achievable with long-term investments, it would likely be wiser for my brother to invest rather than pay down his student loans. Let’s look at the math of these choices assuming an average return of 5% per year and an after tax APR of 4% on his loans.
- Student debt: $20,000 @ 4% APR over 30 years = $95/month
- Investment: $10,000 @ 5% return compounded over 30 years = $45,000
Paying down student debt:
- Remaining student debt: $10,000 @ 4% APR over 30 years = $48/month
- Investing the remaining: $47/month @ 5% return over 30 years = $40,000
In contrast, his credit card has an APR of about 10% and is not tax deductible. Because 10% is too much to ask for an investment return, it’d probably be wiser for him to pay off this debt before investing. Here’s the math for this one assuming it takes 5 years to pay off the credit card making the minimum payments:
- $13/month @ 10% APR for 5 years = $1600
- $10k @ 5% over 5 years = $12,800
- $12,800 – $1600 = $11,200
Paying off credit card:
- $10k – $1k = $9k (to invest)
- $9k @ 5% over 5 years = $11,500
Personal Needs & Goals
The above examples are how most financial planners will present these choices. From a strict ROI standpoint, anyone can clearly see which options make the most financial sense in the long-run. That’s why most financial advisers will probably tell you to invest rather than pay off a low interest loan like student debt or a mortgage. The problem is, this is the real world and other circumstances must be taken into account.
My brother isn’t living beyond his means, but his income right now certainly isn’t overly abundant either. As a guy in his early 20’s, making sure he has enough money to pay the bills is probably a higher priority than saving for his retirement at this point in his life. Reducing his monthly bills is one way he might choose to do that, in which case paying off his student debt makes sense.
Also, he’s mentioned the need for flexibility with the money. Since he’s currently searching for full time employment, he may need to relocate which will cost him some money. Higher return investment options (like an IRA or 401K) usually make your money difficult to access without paying penalties. Similarly, paying down debt doesn’t leave any flexibility at all. I suggested he might put (at least some of) his money into a savings account as a “rainy day fund”. The returns certainly won’t be enough to justify in terms of strict ROI, but it offers him the liquidity [read:flexibility] he needs right now.
Personal goals are an important part of deciding how to plan your financial future both near and far. Let’s say my brother paid off his credit card and put $4k into a savings account for emergency cash. He still has $5k to play with. If part of his goal is to retire early, he’d be wise investing now; the earlier he can start planning for this the better his chance of retiring early will be. In contrast, let’s say he sets a goal to be debt free in 10 years so he can travel without being bogged down with high monthly bills for the next 30 years. In this case, he’d be much better off paying down his debt.
Other things my brother might consider
Available credit –Paying down student loan debt may help improve my brother’s credit score, but it won’t do much to increase his available credit. Almost like saving money for a “rainy day fund” paying off his credit card debt will help make immediate room for emergency credit if the need ever arises.
Company 401k contributions – If my brother landed a job that offered 401k benefits with matching contributions, he would want to take advantage of that. Not only can 401 investments be pre-tax, but leaving potential employer contributions on the table is losing out on instant returns. As a result, he may choose to pay off the student loan debt and reduce his monthly bills giving him more cash flow to take advantage of the higher ROI 401k.
Market health & viability – Right now, the investment market is a big question mark. While my brother understands the concept of long-term investing, he’s worried about losing money in investments early on. He may choose to wait to invest until the economy strengthens a bit before making his decision.
Know thyself – Finally, at the end of our conversation, my brother turned to me and said: I don’t know if I trust myself with this much cash right now. It’s too tempting to spend the money. Even if I invest it, I might be tempted to use it when I find something I want. If I use the cash to pay off my debt, I can’t change my mind later…that’s probably a good thing- for me, anyways….