Presented by Sara Frank-Hepfer, CFP®, AAMS®
Every year I have the pleasure of speaking with some seniors at Michigan State University (Go Green!). We discuss the basics of investing and what the heck this 401(k) thing is. One of the most common questions I receive is whether students should prioritize paying off student loans or saving for retirement. It’s a great question! There is no one-size-fits-all answer.
The first thing to look at is your student loans, are they qualified or non-qualified? Qualified loans may be Stafford or Sallie Mae issuances. Unqualified loans are generally issued by a private bank. What difference does this make? Repaying your qualified loans may entitle you to a tax break on the interest you pay. Unqualified loans do not. (If you like to fact check, here’s the link: https://www.irs.gov/publications/p970/ch04.html)
If you have both qualified and un-qualified loans, what do you do? Prioritize! The loans that have no chance of giving you a tax benefit, your non-qualified loans, should be your priority when addressing debt.
There are two schools of thought on how to tackle multiple loans. The first is that you pay off the highest interest rate debt first. You send that high interest loan extra money while making the minimum payment on your other loans. This method saves more money in the long run.
The other method is called the “snowball,” wherein you pay off your smallest debt first, making the minimum payments on the other loans. Once that first debt is taken care of, you add that former payment amount to your next smallest debt. This method tends to feel better emotionally, as you start crossing loans off your list and you can target a debt-free date.
Paying down student debt should be a priority, but not the only one. I try to emphasize to the MSU students how important it is to start saving early for retirement, how much easier everything will be if they do. Here’s an example of what I mean, borrowed from a Commonwealth Financial Network (my broker/dealer) presentation.
At age 25, Amy decided she wanted to start early and invest $3,600, which is $300 each month. She did this for 15 years at an 8-percent interest rate. She decided to stop at age 40. Assuming that Amy doesn’t contribute anymore, and assuming an average annual return of 8 percent, compound interest, at age 40 she will have $104,500. Additionally, if Amy doesn’t contribute any more after another 30 years, at age 70, she will have $1,050,000, due to compound interest.
John, on the other hand, did not want to think about retirement and just kept putting off saving until age 40. He began investing $300 a month ($3,600 a year), just as Amy did, for the next 30 years. After investing $108,000, he ended up with $450,000 at age 70. Even though John invested twice as much money as Amy, he ended up with half as much simply because Amy had a longer time for compounding to work in her favor. Once again, timing is key.
This is a hypothetical example, does not take into consideration the fees, expenses, and charges with investing, and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.
The above example does not include the possibility of an employer sponsored “match,” either. A match is money that an employer may add to your retirement account to incentivize you to save. If Amy or John had a match from their employer, they would have even more money available for retirement. To learn more about how a match works, you can view a video I made recently explaining the concept at https://www.youtube.com/watch?v=leRscbrIwjg.
The other consideration I want these MSU students to consider is that adding money to their retirement account is tax-friendly. The dollars do not get taxed when they go into the retirement account. They can lower the worker’s taxable income. And since they are pre-tax, you don’t feel them out of your check dollar-for-dollar. One dollar contributed may feel like $0.75 out of your check, depending on your withholdings. They may also help you on the debt management side, as your take home pay would be slightly lower. Often times, qualified student loans will allow you to tailor your repayments to your income. Lower income may mean lower payments on some of those pesky student loans!
Congratulations, seniors! May you have much success in the working world, and may you take control of your financial life. Ask a CERTIFIED FINANCIAL PLANNER™ professional (such as me!) for help addressing your personal debt versus retirement strategy.
Sara Frank-Hepfer is a financial consultant located at Financial Technology, Inc., 1500 Abbot Road, Suite 150, East Lansing, MI, 48823. She offers securities as a Registered Representative of Commonwealth Financial Network®, Member FINRA/SIPC. She can be reached at (517) 351-8600or at firstname.lastname@example.org.
© 2012 Commonwealth Financial Network®
This was printed in the November 13, 2016 - November 26, 2016 edition.