Accelerating Student Debt Repayment Versus Making 401(k) Contributions
Burdened with student debt, many Millennials who have begun to advance their careers face a consequential choice: should they use an increase in disposal income to retire their debt from student loans early or use those funds to contribute to their 401(k) plan? The decision they make could have lasting effect on their long-term financial health.
On the surface it may seem like an obvious decision. If an investment’s return outweighs the interest rate on the loan, then extra income should be directed toward investment. Conversely, if the interest rate on the loan is greater than what can be earned on an investment, then paying back the loan should be the higher priority.
That seemingly simple calculus, however, runs up against some important nuances, like the emotional relief that comes with being debt free, employer-matching contributions and the value of long-term, tax-deferred growth.
Of course, this decision is not necessarily a binary choice; he or she could do both.
Factors to Consider
Millennials who find themselves with increased discretionary income due to a raise or promotion and have not been contributing to their employer’s 401(k) plan should enroll immediately. They should, at a minimum, contribute up to the level of any employer match. The employer match represents an unparalleled opportunity to grow wealth. For those already contributing to a 401(k), but not taking full advantage of the employer match, they, too, should consider raising contribution levels as a first priority.)
Provided an individual is taking full advantage of the employer match, the decision becomes more about the relative cost of outstanding loans versus the potential investment return, though there are additional factors to consider.
The most important one is that such calculations are typically over a like period of time, (e.g., prepaying over five years saves $X in interest compared to earning $Y in an investment). Retirement saving requires a different perspective.
Take the example of an individual who can save $5,000 in interest by retiring a loan early versus accumulating $4,000 in an investment. Which is the better choice? At first blush, it seems like paying off the loan early is the better option. But what becomes of that $4,000 in the 401(k)? Actually over the next 20 years, its value grows to almost $13,000, assuming a 6 percent return. Which is the better choice now?
Helping Millennial Clients and Prospects
The retire debt or contribute to a 401(k) question is not always strictly a financial calculation. There is significant emotional value to putting burdensome student debt in the rear-view mirror.
Whatever the case, advisors can play an important role in assisting young investors through these decisions. Here’s a tool that can be helpful in guiding those conversations.
Please reference disclosures: https://blog.americanportfolios.com/disclosures/