What's On First -- Paying Off Student Loans or Saving for Retirement?

Paying off student loans is, in effect, keeping young adults from investing in their futures. It's bad for them -- and bad for the economy as a whole. But it doesn't have to be this way.
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Dear Carrie,

I'm 24 and came out of school with $80,000 in college loans. I've been luckier than most of my friends and have a full-time job, but I'm wondering whether I should pay off my loans before I start saving for retirement. What do you think?

-- A Reader

Dear Reader,

This is a great question and absolutely timely. With total student loan debt now topping 1 trillion dollars, there's a lot of concern about how this debt is preventing young people from buying a home, saving for retirement, or starting their own families. Paying off student loans is, in effect, keeping young adults from investing in their futures. It's bad for them -- and bad for the economy as a whole.

But it doesn't have to be this way. It all depends on how you prioritize. You -- and every graduate who's struggling with debt -- can make choices on how to pay down your loans that will help balance past obligations and future goals.

Obviously, you have to pay at least the minimum on your student loans and never miss a payment. But beyond that, you can create a system to stay on top of your loans while at the same time contributing to your financial future.

Understand the difference between "good" debt and "bad" debt

The first thing is to realize that not all debt is equal. Some of it can actually work for you. For instance, debt that's lower cost, and potentially tax deductible, such as a mortgage or a student loan, falls into the "good" debt category.

On the other hand, high-cost debt such as credit cards and car loans is definitely in the "bad" debt category. It's the most costly, especially over time. Plus, you're borrowing to own something that depreciates. Think about what happens the minute you drive a new car off the lot.

Good debt can actually be a financial tool. Bad debt can be a financial nightmare. So your goal should be to shed the bad debt as soon as possible, while systematically paying down the debt that's working for you.

Strike a balance between debt payment and saving

From my point of view, your top saving priority should be retirement. So once you've accounted for the minimum payments on your student loans, here's how I suggest you prioritize your savings and payments:

  1. Contribute enough to your company retirement plan to take full advantage of your employer match. This puts extra money in your pocket.
  2. If you have a credit card balance or a car loan, focus on paying those down next, starting with the highest interest.
  3. Build an emergency fund to cover at least 3-6 month's essential expenses.
  4. Save more for retirement. The good news is that because you're starting in your twenties, you should be in good shape for retirement if you can save 10 percent of your gross salary throughout your working years. (Those who postpone starting to save for retirement have to increase this percentage.)
  5. To me, these first four points are important for everyone. Once you have a handle on them, you can tackle the following goals according to your personal preference.

  6. Save for a child's education. (Notice that retirement comes first.)
  7. Save for a home. (Again, retirement first!)
  8. Pay down other debt. This could include increasing your student loan payments if you can swing it.
  9. Save even more. Once you have money saved beyond your emergency and retirement funds, add to your long-term savings in a taxable account.

These final four savings priorities will vary in importance as your life changes. The main thing is that you keep saving even while you're paying down your student debt.

Understand the difference between saving and investing

As you look ahead, it's also essential to understand that saving for the future and investing for the future are two different things. Saving means putting your money in a safe place, for example in a federally insured bank account. You won't get a big return, but when it comes to your emergency fund or any other money that you know you will need in the next three to five years, safety is paramount.

When you're preparing for a goal that is many years out (such as retirement), however, it is appropriate to invest your money in the stock market so that you have the potential to outpace inflation. Don't hesitate to consult with an investing professional as you build a diversified portfolio.

Stay on top of your student loans

Don't get me wrong. It's great that you're focusing on paying off your student loans right away. As you figure out your other savings and payment priorities, you'll want to continue to keep a sharp eye on them. To make it easier, organize your loan documents so that you always know the amount owed, interest rate, term of the loan, minimum monthly payment, and repayment date. A simple spreadsheet should do the trick.

Also explore repayment options. Federal loans have more repayment alternatives than private loans, including graduated repayments, income-based repayments and public service loan forgiveness. Consider consolidating loans to possibly lower interest rates and monthly payments.

Make it all automatic

Finally, put as much as you can on auto-pay -- monthly bills, including student loan payments, and your savings. Your 401(k) contributions automatically come out of your paycheck, but don't stop there. You can set up automatic transfers from your checking to your other savings accounts as well. Once you have money to invest, you can even direct your savings automatically into a brokerage account to start building a diversified portfolio.

I give you a lot of credit for taking your student loans seriously, and for thinking about retirement this early. If you can handle both, you'll be putting yourself in a good position, not only to enjoy the benefits of your education, but also to handle with greater confidence whatever the future holds. Best of luck!

Looking for answers to your retirement questions? Check out Carrie's new book, "The Charles Schwab Guide to Finances After Fifty: Answers to Your Most Important Money Questions."

Read more at http://www.schwab.com/book. You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.


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