Buzz
When you're tackling significant debt like student loans, it can be tough to figure out when it's the right time to ramp up your efforts to pay it off. Should you funnel all your extra money into your loans, or should you shift your focus to saving for the future?
It's a bit like the classic tortoise and hare race. If you sprint, you'll clear your debt faster, but other aspects of your finances may lag behind. If you take it slow and steady, the debt may feel overwhelming, even though you could be in a stronger position in the end.
Luckily, there's a straightforward way to decide how to balance paying off debt and investing—one that removes the guesswork and relies solely on numbers. In fact, just one number: your interest rate.
If the interest rate on your debt is lower than a conservative return on your portfolio, prioritize investing. If your debt's interest rate is higher than that return, focus on paying off the debt.
That ideal number depends on how much risk your investment portfolio is exposed to. However, you can generally expect an annual return of around 6%-8%, once the market's fluctuations are smoothed out.
So, if you anticipate a 6% return from your portfolio this year and your student loan interest rate stands at 8%, you'll likely want to prioritize paying off the debt faster than your portfolio's expected growth.
If you're projecting a 6% return and your student loan interest rate is only 4%, investing would likely make more sense.
Want to simplify it? Just remember the number five. Some experts call this the 5% Rule, as shared by Mytour alum Kristin Wong in the New York Times. Rather than focusing on your rate of return, use 5% as your tipping point to decide whether to prioritize debt or investing.
When you analyze it this way, it becomes clear why paying off consumer debt like credit cards is crucial—and why you can be a little less anxious about your student loans. With a credit card, your debt can increase by as much as 30% annually, whereas your investments will grow by less than 10%. You're losing money at a much faster rate than you're gaining it.
One important note: This approach is most effective for those with investment portfolios outside of tax-advantaged accounts. If your employer offers a retirement match, it's wise to contribute, even if your student loan interest rate exceeds 5%, says Erin Lowry for Money. You don't want to pass up that free money.
