Financial Priorities: Should I Pay Off Student Loans or Save for Retirement?
Daily Origami is a way for us to record our off the cuff thoughts, feelings and observations about the world around us. Published every weekday, Monday through Friday.
Recently, this Oprah quote has been floating around the financial blogosphere:
I’m going to do my best to ignore the survivorship bias of a multi-billionaire telling her followers they can (eventually) have everything, and focus on the finer point she’s making about financial priorities.
What Should I Prioritize First:
Debt, Savings or Retirement?
Companies selling retirement products tell you to prioritize retirement. Student loan refinancing companies tell you to prioritize paying off your loans. Mortgage lenders tell you to save for a down payment because real estate values always go up, and nothing we’ve experienced in the past decade would suggest otherwise.
What I’m telling you is this: run the numbers yourself.
Here’s What You Can Do Right Now / Are Doing Already:
But first, nothing in this series is going to make sense until you’ve done the following:
- Have / Create a budget and are living within your means
- Make minimum payments on your student loan
- Have a 2-3 month fuck off fund
- Ensure you’re paying the lowest possible rate on your loans
- Contribute to your company 401k up to the employer match (if available)
- Avoid other high interest loans including: credit cards, personal loans, new car loan
Should You Pay Off Students Loans First Or Save For Retirement?
As I’ve covered in my Daily Origami post True Value of Money, the cost of a financial decision is the value of the next best alternative. This is called opportunity cost.
So the question of “should I pay off my students loans first or save for retirement?” could be rephrased as:
What return am I giving up
when I use my money to pay my student loans first?
In other words, you weigh the expected return of investing for retirement against the interest you pay on your loan.
Now before I get into the nitty gritty, I have to make the following assumptions:
- A 5-6% interest rate on the average student loan and an average debt balance of $40,000
- Retirement savings would be 100% invested in a low cost index fund like Vanguard’s Total Stock Market Index Fund (or VTSAX), popular with the early retirement FIRE crowd. This means no stock picks, no Bitcoin, and no tulips.
Figuring Out the Market Return
Since we already know what interest rate we’re paying on our student loans, our only unknown is the market return we’re giving up.
But first, a primer: The market is composed of companies. Companies make earnings (or profits). Earnings can either be distributed to shareholders in the form of dividends or reinvested back into the company to grow future earnings.
Thus, in the long term, say over a decade, the annual return of the market can be boiled down to the following formula:
Market return =
Dividend yield + Future earnings growth
Since the future obviously hasn’t happened yet, we can only look back on the data available for the last twelve months:
- The dividend yield of the S&P 500 index is 1.89%.
- At current valuations, earnings growth will be anywhere between 3-5%
And when I say valuations, here’s where we are today.
This is the Shiller cyclically-adjusted price to earnings ratio. Without going into too much detail, the higher the ratio is, the more overvalued US stocks are. The highest point on this chart was during the height of the dot-com bubble in 2000.
Notice we’ve gone eight years since the 08-09 recession, and valuations have moved past the levels seen in 2007.
This suggests that future earnings growth over the next decade will be at the low range of 3-5%. Let’s use 3% to be conservative.
Our estimated market return will be as follow:
Dividend yield (1.89%) + Future earnings growth (3%) = Market Return (4.89% )
Assuming a $40,000 student loan debt, your answer is pretty clear when you do the math.
Even if the numbers were roughly equal, debt affects your life today in ways that not saving for retirement right away wouldn’t - especially if you’re still young:
- Debt severely limits your options and prevents you from taking risks that could grow your future income (e.g. starting your own company or taking that lower paying but bigger upside job).
- Paying off debt gets you into the habit of saving, which can only benefit your retirement goals in the long run.
By running your own numbers, we can conclude that in 2017, it’s probably never made more sense in all of financial history to prioritize paying your student loans (and other debt) off as quickly as possible.