Why One Couple Decided To Pay Off Student Loans Before Investing

There are three kinds of questions when it comes to personal finance.

  1. The first are those with objective answers like what tax bracket you’re in or whether you would be subject to a penalty for withdrawing from your retirement account.
  2. The second are those with a pretty strong consensus among financial planners. For example, most would say that you should generally build up an emergency fund, contribute at least enough to your employer’s retirement plan to get the match, and pay off high-interest debt like credit cards.
  3. Then there are the questions whose answer depends on you.

When the answer isn’t clear cut

For example, I was recently talking to a young couple who had all their financial basics covered. They had sufficient emergency savings, no high interest debt, and were contributing enough to their retirement plans not only to get their employer matches but also to be on track for retirement. They still had enough savings to either pay off their student loans, contribute more to their retirement plans, or save for a down payment on a rental property. Their best option wasn’t so clear here. Let’s take a look at each option:

Option 1: Paying off the student loans

This is the most conservative choice. Since the interest rate was 4.375%, they were essentially earning a guaranteed 4.375% on any savings they put towards the loans. Try getting that rate at the bank or anywhere else for that matter. Paying off the debt would also provide an emotional benefit of not having the burden of the loan payments and would improve their debt/income ratio, which would help qualify for a better rate on a mortgage for the rental property.

Option 2: Contributing more to their retirement plans

This option would reduce their taxes now and probably overall since they’re likely to be in a lower tax bracket when they retire. They’re also likely to earn more in their retirement accounts than what they would save in interest by paying down the student loans. However, the money would be relatively tied up until retirement (which wouldn’t normally be a problem but they’re already saving enough to be on track to their goal) and there’s no guarantee their investments will earn more than the 4.375% they would save in interest by paying down the loans.

Option 3: Saving for a rental property

A rental property can help them achieve their goal of passive income and the ability to use leverage can provide a higher return on their investment than even investing in stocks. This makes it the most aggressive choice, almost like starting a business. But like a business, real estate is complicated, time consuming, and extremely risky. After all, you can lose more than what you originally put in due to maintenance costs and having to make mortgage, tax, and insurance payments while the property may be vacant.

What they decided to do

Given that they have adequate emergency savings and are currently contributing enough to their retirement plans to hit their goals, I personally probably would have focused on saving for the rental property (which is pretty much what I’ve actually been doing with my savings). However, they decided to knock out the student loans first while contributing extra to their retirement accounts. There isn’t always one right answer. Sometimes the best decision is a personal one.

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