Most of us know how important it is to save for retirement -- but setting aside 10% to 20% of every paycheck isn't easy, especially if you're paying off student debt. Young workers who are lucky enough to have some extra money left over at the end of the month may face a tough decision: to pay down their college debt faster, or to invest their spare cash in a retirement account. And their choice can have a major impact on their future finances. 

There are benefits to paying debt off early, like reducing your interest payments and relieving yourself of a financial burden. That said, funneling your money into student loan payments instead of a retirement account could shrink your ultimate retirement savings by much more than you realize.

Here are some things to think about before you make your next payment.

A close up of a woman's hands on a calculator while planning finances.

Image source: Getty Images.

The power of compounding

Let's play out a few scenarios for Jane Doe. Jane has an extra $1,000 per month after paying taxes, monthly bills, and her minimum student loan payment. She has $50,000 in student loans at a fixed interest rate of 5% on a 20-year loan schedule, so her minimum monthly payment is around $330. Here are a few scenarios that show how Jane could pay off her debt and how that would change the total interest she pays. 

Monthly Student Loan PaymentMonths to Pay Off BalanceTotal Interest Paid
$330 (minimum payment only) 240 $29,195
$830 (minimum payment + $500) 70 $7,693
$1,330 (minimum + $1,000) 41 $4,493

Data source: Bankrate loan payment calculator.

Jane could save a lot of money by paying her loan off quicker -- but that could still be the wrong move. If Jane took the extra money she was paying into her student loan and instead put it in an investment account earning an average of 8% per year, her financial picture would look far different by the end of that 20-year loan period. Even if she didn't add anything else to her account for 20 years after that, she'd earn far more than she would have saved by paying off her student loan faster.

Monthly Retirement Savings During Loan PeriodMonthly Investment After Student Loan Completion Account Balance in 20 YearsAccount Balance in 40 Years
$1,000 (for 20 years) N/A $589,020 $2,745,397
$500 (for first 70 months) $1,330 (after 70 months) $555,253 $2,588,010
$0 (for first 41 months) $1,330 (after 41 months) $549,005 $2,558,888

Data source: Bankrate simple saving calculator.

The benefits of saving for retirement early usually outweigh the benefits of paying more than the minimum on student loans. If Jane makes the minimum payment, she spends $24,702 more on interest, but she ends the loan period with $40,015 more in her retirement account -- a $15,000-plus difference that keeps compounding and growing down the line. However, not every situation is that simple; here are some other considerations to take into account. 

1. How much should I have in an emergency savings fund?

Before getting more aggressive about either paying down debt or investing for retirement, it's usually wise to set aside some cash in an emergency fund that could keep you afloat in case of a job loss or other unplanned emergency. The amount you should have in such a fund varies based on personal circumstance, but usually, a good rule of thumb is to have enough to cover six months of expenses

2. Can I max out my employer's 401(k) match?

Many employers that offer a 401(k) retirement savings program will also match a certain percentage of your contribution into that program. For example, an employer might offer a 100% match of contributions up to 5% of the employee's salary, so that if the employee makes $50,000, and contributes 5% of their salary ($2,500 per year), then the employer will deposit $2,500 more into the account. Whatever type of match your company offers, these programs should usually be prioritized at least up to that match limit, since it's essentially free money -- a bonus on top of the employee's salary, and one that goes into a tax-advantaged account.

3. What are my interest rates?

One of the most important factors in the decision about whether to pay off debt faster or invest is the interest rate on the loan. In Jane's case, her 5% loan interest rate is substantially less than her expected 8% average annual return on her investments. While no one can guarantee any investing returns (more on this next), you do know your fixed loan interest rates, and you can calculate with precision how different payoff schedules would change the total amount you pay in interest.

However, that's not the case when the loan interest rate is variable, rather than fixed. Many lenders will offer a lower initial rate, but that rate could increase in the future. In the instance of a variable-rate student loan, it might make sense to explore a consolidation that could change that to a fixed-interest loan. 

4. Can I stay long-term minded?

No one can say with certainty how much their investments will earn. Still, when you invest with a time horizon of decades -- i.e., don't day-trade, but buy stocks with the intention of holding them for many years to come -- you can feel pretty good about your odds of profiting when you look at historical trends.

The S&P 500, often used as a benchmark for the broad market, has, on average, risen 9.5% annually since 1928, 10% annually since 1967, and 7% annually since 2007, a period that includes the major recession of 2008. The market experiences up and downs, but over long periods of time, its upward march has been quite consistent. So if you tolerate a bit of risk, keep your head when the market gets choppy, and stick to a buy-and-hold investing strategy, then your portfolio should do just fine.

Of course, you should always make sure you set aside enough money to make your minimum loan payments. Missing payments can trigger late fees and do serious damage to your credit score. Beyond that, you're probably better off putting leftover funds into retirement savings. prioritizing saving for retirement is more profitable than paying off student loans faster.

All that said, each individual's situation is unique and influenced by factors such as the number of years until expected retirement, estimated future cash flow needs, and tax implications, among others. One way to figure out the best course for you is to map out how different options would work for you using tools such as Bankrate's loan calculator and savings calculator, which allow you to input your own details and see what various scenarios could mean for your future.

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