What is arguably the most common financial burden among young adults? You guessed it. Student loans. Chances are you have them, had them, or know others who do (or did). But as proud as we are about our accomplishments in higher education, there’s something to be said about the enormous burden of student loan debt both on a national and personal level. Sometimes it’s hard to navigate what to do with our money if we want to be responsible in paying off our debt while yet, looking ahead to the future. Is it possible to pay off loans while simultaneously saving for things like retirement? Can progress actually be made while doing both? In order to answer this question and make the best decision, we first need to understand the power of compound interest. Second, this is a broad overview, so each person’s situation is going to look different. There is no one-size-fits-all method to follow, but with examining all the factors, we can create a plan that is specific to our situation.
Compound interest is simply interest earned on interest, and it is either working for us or against us. As in the case of student loans, it most definitely is not working in our favor. I like to think of it as basically throwing money out the window. Generally, compound interest is accrued daily and compounded monthly. Each consecutive month, that interest is added to the sum of the principal balance and the previous month’s interest, and it will continue to compound, leaving us with a much larger loan balance than what we initially borrowed. It doesn’t take much to figure out how this can quickly become a big problem. Keep in mind there are variations to this depending on loan amount, interest rate, compound frequency and term.
In terms of investing, rather than having a detrimental effect (increasing the overall amount borrowed), compound interest works in our favor, increasing the overall amount on deposit. With each passing month, quarter, etc. the interest accumulates and compounds, and the cycle continues. The obvious advantage here is the money can grow rather quickly, depending on the balance and interest rate, and in the case of investing for retirement, this is a good thing!
Now that we have a better understanding of compound interest, how will we decide the best route to take?
Build a budget. We need to look at the cash flow in our budget in order to determine how much excess we are working with. If our monthly surplus is large, that gives us the freedom to determine which goals are priority. Is it more important to tackle those loans quickly and then funnel that excess towards retirement? Or is there an employer match or other incentive for retirement to capitalize on, while paying the loans off at a slower pace?
Compare the interest in both scenarios. If your goal is to pay off loans while saving for retirement, a little math should help guide your decision. It may be a good idea to consult your financial advisor about your investments, or use an online loan payoff calculator to run the numbers. You can compare the interest amount in both scenarios using the same term (i.e. 10 years, 15 years, etc.) to get a clear picture on which route will be more costly.
Here’s my honest take. If we simply pay the minimum payment, it’s very likely a significant portion of that payment is applied just to interest alone, without even reducing the principal balance, which means we’ll be paying on those loans for a long time. Some of us are on track to pay off those loans in ten, fifteen, or twenty years, which is honestly just a financial nightmare, especially if the loan amount is substantial or the interest rate is high. I get so passionate about this because although we are keeping our lenders in business, we are literally throwing away hard-earned money. If time is on your side, I personally have seen the most effective plan is to payoff those loans first and fast, and then grow the retirement fund. If you’re looking for a way to pay off debt, you can find my debt payoff strategies here. Financial struggles can be your past, but they don’t have to be your future. Get a plan, set your goals, and do the work to get where you want to be financially.