Financial advisers recommend that you save roughly 10-20% of your income towards retirement, and the sooner you begin, the greater the outcome due to the beauty that is compound interest.
However, if you have recently graduated from college, you probably have a fair amount of college loan debt. Should your income go towards paying off that debt faster or saving towards retirement?
Invest in your retirement as soon as you can.
Unless your student loan interest rate is quite high (>6%), you should pay nothing more than your full-monthly payments towards your student loans, and try to save as much as you can towards retirement. The younger you begin saving, the more money you will have when retired. This money will grow (hopefully) at a rate greater than the interest on your student loan payments.
Want to know the nuts and bolts of why? Keep on reading. If you don’t, return to whatever you were doing. Click on a few ads as you leave.
The recommendation to pay more towards your student loans only if the interest rate is north of 6% comes from expected rates of long-term returns for index funds and the effects of compound interest. If we look at the long-term performance of the stock market, we see a roughly 9% return on investment (I do stress that this is a long-term view of historical performances, which do not equate to future performances. Also, in that long-term trend, there have been periods where market value decreased by 10-50%). This 9% return is obviously higher than the 6% interest on your student loans. So, by investing towards your retirement rather than paying extra towards your student loans should be a net gain long-term.
In addition, you get an extra boost by using those funds to invest in your retirement than by paying extra towards your student loans. Let’s assume that with your budget you had an extra $1000 to spend, and were thinking of using that money to pay extra towards your student loans. That is post-tax dollars. If you can save $1000 in post-tax dollars, then you can save $1333 in pre-tax dollars assuming that you are in a 25% tax bracket. This $1333 can go into your 403b or IRA retirement account.
Compound interest gives you an extra benefit. Investing this $1333 early and giving your money a few more years to compound can have a drastic impact on the balance of your account when you retire. Assuming 9% return on investment, allowing that $1333 to compound for 30 years gains you an extra $4300 compared to allowing that $1333 to compound for 25 years ($13,400 vs $9,100 respectively). Also, if you can invest $1333 every year for five years, that $6665 alone will compound to $57,800.
Read more about compound interest here.
Last thought – saving for a retirement has an added benefit if you are worried about paying for your child’s college education. More about this to come in a future post.