How You Should Be Prioritizing Your Finances

Photographed by Raven Ishak.
We’ve written a lot about setting up an emergency fund, saving for retirement, and investing in your future. Unfortunately, many of you are struggling with student loan debt, and it can feel like every single extra penny should go to paying it off. Isn’t the goal to get rid of that debt as quickly as possible, and then start putting away any extra money for the far-off day when you might be able to retire?

There are lots of different schools of thought on this topic. We asked the experts at Earnest, a startup that offers student loan refinancing among other financial products, to crunch some numbers and give us advice for that new-age question: invest or pay down your student loans?

As a general rule of thumb, according to some investing experts, if your loan APR (annual percentage rate) is in the range of 5% or more, then you should prioritize paying it down over investing. If your APR is less than 5%, then you should prioritize saving money and investing — this is particularly true if your loan interest payments are tax deductible and/or you can lower your income taxes by using tax-advantaged accounts such as a 401(k). But is there a way to fund your retirement and pay down your student loans so that you can move on to other things in life?

Let's look at a hypothetical example: Allison just finished law school and is starting a new job in New York City. Her annual salary is $160,000, which is near the median for first-year attorneys. She has $100,000 in student loans, on which she’s paying an average APR of 7.5% over a 10-year term.

One way to start saving almost immediately is by looking at your loan APR and seeing if you can get a lower rate.

After taxes and her 401(k) contribution (she’s saving 10% of her salary each month), Allison’s monthly take-home pay is $6,615. She pays $1,187 a month in student loans and has an additional $5,313 in expenses, including rent and food. This doesn’t leave her much to save each month. While Allison is doing a great job saving in her 401(k) at work, she has very little other savings. As she looks at her budget, she wonders if she’s doing the right thing.

One way she can start saving almost immediately is by looking at her loan APR and seeing if she can get a lower rate. With her professional job and a solid track record of responsible money management, Allison can refinance her student loans at 7.5% APR down to 4.7% APR. That move reduces her monthly payment from $1,187 to $1,046 for a 10-year loan, for a savings of $141 per month — or $1,692 annually.

With some further research, Allison discovers that there are other ways that she can save even more money:

If Allison reduced her student loan budget to $800 per month and extended the term of her loan to 14 years and nine months with 5.1% APR, she could start saving more for retirement right away. That lower loan payment nets her a total savings of $387 per month — or $4,644 annually. The total interest she’ll pay over the life of the loan will be almost $43,000.

If Allison increased her student loan budget to $1,850 per month, she could finish her student loans in five years and three months at an APR of 4.3% — with an important caveat. This plan would require that she cut her 401(k) savings rate to 4% to increase her monthly cash flow in order to afford that payment. Her total interest paid on her loan would be approximately $11,350.

In order to decide which scenario is best, it’s important to look far into the future, when Allison is 67 and retiring from her legal career.

If Allison saved 10% of her salary in her 401(k) from ages 25 to 67, she could have $4.4 million in her 401(k) by age 67 (if her average return was 7%). If she opted to save only 4% of her $160,000 salary for the first five years (while aggressively paying off her debt) and then bumped up to 10% at age 30, she should have $3.5 million at age 67 with the same return. While she might have paid more for the loan in the short-term by going with the longer repayment plan, she’ll make almost a million more in the long run. It’s simple proof of the power of compound interest in your long-term savings plans.

If Allison saved 10% of her salary in her 401(k) from ages 25 to 67, she could have $4.4 million in her 401(k) by age 67.

By refinancing and/or pushing out a low-APR student loan, Allison was able to save more for retirement over the longer term — she also had money to build an emergency savings fund (experts recommend having the equivalent of three to six months of expenses) and even start saving for a home down payment earlier in her life.

On the other hand, if she pursued the aggressive payment plan, she’d have to wait until she was 30 to start saving more for retirement as well as other goals. While she would have the means to save much more after her loan payments were finished (including $32,000 in saved interest), she would also need the financial discipline to play catch-up — and would have lost key time in the market.

Of course, there’s no one right answer that fits every person. Paying off your student loans sooner has an intangible reward that goes beyond economics: Psychologically, it can be freeing to no longer have monthly student loan payments.

Every individual with student loans has to weigh the combination of personal savings goals, income, financial discipline, projected earnings, and more in order to find the right balance. But no matter what, you should look for ways to increase savings in your budget early on in your career. That’s your money on the table. Use it wisely.

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