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Should I use my excess income to pay off student loans or save/invest?

I'm a year into my first career job out of college. I'm able to meet my expenses and have a little money left over at the end of the month. Long term, would it be better to start saving/investing my extra cash or use it to pay down the student loans?

Jan 16, 2012 by Lacey from Birmingham, AL in  |  Flag
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Kristin C. Harad Level 12

Lacey, The answer to this question has a few parts. What is the interest rate on the loans? How much money do you have in savings (Cash) that you could access in the event of an emergency? What are your retirement/long-term goals?

In general, the way to determine when to accelerate debt payments is based on the opportunity cost of the money. If your money is earning 1-2% and you have a 5% loan, then in most cases you would want to pay off the 5% loan rather than invest at 1-2%. If however, you can invest at 7-8%, as you may be able to in an appropriately allocated long-term portfolio, then you could continue borrowing at 5% and invest at the higher rate.

Unfortunately, investment returns are not known in advance and can vary. Debt can also mentally weigh down your spirits if you do not see the outstanding balances diminishing in size over the years. And, most importantly, you could put yourself at risk of expensive borrowing if you do not have enough emergency cash on hand to manage through surprises.

What I like to see my clients do is a multiple-pronged approach, focusing first on what I call the "bookends." The bookends are Emergency Savings (cash on hand) and Retirement savings (your long-term security). If you do have at least one month's expenses in the bank for an Emergency Cushion, then direct ALL excess cash here until you reach this first threshold. After you achieve that level, then split your excess for investments between Emergency Cash and Retirement (assuming your loan rate is lower than your projected return on investment). You want to build up to six months of expenses (this will take time) in cash in the bank for an Emergency reserve fund and also focus on achieving your target Retirement contribution for the year (you can figure out this number by working with a Financial Advisor or using an online tool if you do not want personal advice). Over time, once you start accumulating savings for the short-term and investments for retirement, you can add in accelerated payments to your loans.

Comment   |  Flag   |  Jan 16, 2012 from San Francisco, CA

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