Pay off student loans or invest more?

Are you paying off student loans? If so, you’ve probably heard some version of this advice:

“The sooner you start investing, the more time your portfolio has to grow through the magic of compound interest. But if you wait to get started until your student loans have been totally paid off, you’ll miss out on a lot of that precious time.”

That’s how a student loan consolidation firm, SoFi, puts it.

And the idea makes intuitive sense. If your student loans charge 3.86% interest (the current rate for federal undergraduate Stafford loans), why hurry to pay them off when you could earn 7%, 8%, even 10% in your investment portfolio?

The recent grad who puts all of her potential savings toward prepaying her student loan (after taking her 401(k) match, of course) might not get a real start on retirement savings until six or more years into her career.

That can’t be a good move. Can it?

Lisa and her loans

Meet Lisa. She’s a new grad with $30,000 in student loans—about average, according to the Project on Student Debt. Furthermore, we’ll stipulate that all of her loans are at that 3.86% rate.

Lisa’s minimum monthly payment, on the standard 10-year repayment plan, is $300. But she got a decent job at an accounting firm and could put up to $500 per month toward debt repayment and savings combined. Her 401(k) doesn’t offer a match. Yes, Lisa is extraordinarily lucky to have a job and be able to pay extra on her loans.

Lisa asks her financial advisor, “Should I pay down these loans ASAP or pay the minimum and invest the rest?”

Her financial advisor, Barbara, makes a spreadsheet. Barbara assumes a 7% return on Lisa’s balanced investment portfolio. To keep the scenario simple, Barbara doesn’t includes taxes or raises in the model, and assumes Lisa will retire in 40 years.

By paying $500/month on her loan, Lisa will get rid of her debt in 5 years, 7 months. At the end of 40 years, if she continues to save $500/month, she’ll have a balance of $266,338 (adjusted for 3% inflation).

Say Lisa pays the $300/month minimum on her loan and puts the rest into her portfolio. Now, at the end of 40 years her portfolio is worth $274,385.

Those five lost years of investing cost Lisa a whopping $8000.

The trouble with loans

I’m sharing my spreadsheet with you so you can play with other scenarios: what if Lisa expects to earn more on her portfolio? What if she can save more money per month?

It never makes a huge difference in the end, unless Lisa can somehow keep her loans around for more than ten years and consistently save every month, which is unlikely. But in every scenario, it’s true: Lisa ends up with more money in the end by paying off her loan slowly and investing early.

So everyone must be right: hang onto your low-interest debt while you build your nest egg.

Not so fast. There’s a huge flaw in this reasoning, and it has to do with risk.

When one investment earns more than another, we can usually conclude that it’s riskier. Why do stocks tend to earn more than bonds? Because stocks are riskier than bonds, and investors demand higher returns to compensate for the risk.

“Risk” here means something very specific: it means that we don’t know what the final portfolio value will be. If I buy a 5-year bank CD paying 2% interest, I know exactly how much it’ll be worth when it matures (except for inflation). If I buy a stock market mutual fund, how much will it be worth in five years? I can make an educated guess, but the actual result will be somewhere within a wide range of outcomes.

In the “invest now, pay off the loans later” scenario, Lisa makes more money because she’s taking more risk. She’s taking more risk by investing on leverage. “Leverage” is when you borrow money to invest.

I know it doesn’t look like Lisa is borrowing money to invest. She has this student loan from her college days, and she’s investing. It seems unrelated.

But imagine a world where, to encourage higher education and retirement saving, the government offered a line of credit to college grads. Borrow up to $30,000 at about 4%, and use the money to kickstart your retirement portfolio.

It’s not necessarily a bad idea, but it’s easy to see that anyone taking advantage of the program would be taking more investment risk: your portfolio might drop to $28,000, but you still owe the full $30,000.

But it’s less risky than what Lisa is doing if she chooses to invest instead of paying down her loan, because she already spent the money on college.

Pay it down

Lisa is also taking other kinds of risk by keeping her student loans around. She might lose her job and be unable to pay her loans, which would then go into default, rack up scads of penalties, and demolish her credit score. Some of her loans might have a variable interest rate that could go up.

Yes, there are hardship provisions for student loans, but they’re far from perfect—and yes, Lisa should maintain an emergency fund in case she loses her job.

Lisa should also put some value on how good it feels—emotionally and physically—to get out of debt. A growing body of evidence suggests that debt is bad for your health—not just severe debt, but manageable day-to-day debt, too.

Given all this, it makes very little sense for Lisa, or anyone else, to work on saving for retirement before she pays off her student loans. Her financial priorities should look like this:

1. Get the 401(k) match (if available)
2. Save a modest emergency fund
3. Pay off student loans
4. Save for retirement

Finally, while we’re inventing hypothetical people, let’s recognize that in terms of savings, Lisa is far worse off than a recent grad who minimized their student debt by attending an affordable college.

Matthew Amster-Burton is a personal finance columnist at Mint.com and author, most recently, of Child Octopus: Edible Adventures in Hong Kong. Find him on Twitter @Mint_Mamster.