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Students loans vs. mutual fund

Chris Farrell Jun 22, 2011

Question: My question is about how best to pay down my student loans and whether I should try to pay off some loans with lump sum payments. I have about $68,000 in student loan debt from graduate school and currently, my monthly payments are about $500/month. I work in the non-profit world and I chose to put myself on a 30-year plan to make the payments affordable (there were so many choices, but based on monthly payment amounts and interest, IBR was not the best). I make a good income for the non-profit world and I have saved a lot in my ten years since college. I have $24,000 in my 401K and I am putting away 5% of every paycheck. I want to be able to save more for retirement and have more spending money each month, but the monthly loan payments are making that difficult.

The student loans are my only debt and the interest rate on the loan I am thinking of paying off is 6.55%. My question is: should I continue to just pay off my loans, perhaps switching to a ten-year plan, or should I use some of the $18,000 in my regular savings account to pay off one of my loans? My savings is in one of those awesome accounts that earns only 1.1% and I am debating between taking $5-8,000 and buying a mutual fund or using $8,000 to pay off a loan. What do you think I should do? Thanks much, Erica, Brooklyn, NY

Answer: I used to live in Carroll Gardens, Brooklyn, back in the days when it was still mostly an Italian neighborhood. Brooklyn is one of America’s crown jewel cities.

New York is expensive and your budget is pinched. In thinking this over, in your particular case I would focus on paying down the debt. I would not completely drain your savings to do it, however.

Here’s one way to think about it. If you put $5,000 to $8,000 toward debt you’ll earn a 6.5% return on your money. Odds are you could match that performance over time in a low cost equity mutual fund. However, the advantage of attacking the debt more aggressively is that eventually it will free up cash flow and you’ll be on solid financial footing.

In other words, taking a chunk of money from savings to make progress against the debt is okay. But you’ll still need to keep some in reserve.

I wouldn’t officially shorten the life of the student loans. There’s no prepayment penalty with student loans so you can pay it down faster on your own (and put the extra payments toward principal).By keeping the longer repayment schedule you maintain the option of immediate financial relief if your money circumstances suffer a setback.

The basic financial strategy is save for retirement; aggressively target student loans; and maintain an emergency fund (just in case).

I know a lot of our listeners and readers have dealt with or are dealing with a similar trade-off. Any other thoughts for Erica?

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