How graduating with debt can affect your retirement savings
Posted April 21, 2016
Graduation season is upon us, and millions of Americans will be leaving college to make their way in a sometimes-uncertain job market.
But these young professionals aren't making their journey alone. Many are bringing thousands, if not tens of thousands, of dollars in student debt with them.
And while some students are highly optimistic about their future, equipped with new skills and bona fides that will boost their earning potential and help them pay off their loans, they might not understand the long-term impacts of student debt.
Retirement seems ages away, but a new study from HelloWallet suggests that graduating with student debt tends to reduce retirement savings significantly. Every dollar of student debt means 35 cents less at retirement. According to CNN, this phenomenon is consistently found at all income levels.
While graduating debt-free is generally not an option for most students, there are a few things you can do early to mitigate the effects of debt and maximize your retirement savings.
(Note: Consult a qualified financial professional before making any major financial decisions)
Don't pay off your student loans right away
If debt causes less retirement saving, shouldn't you become debt-free as soon as possible? Not necessarily.
According to Fidelity Investments, you're better off contributing immediately to a retirement fund than making large payments on student loans.
Thanks to compound interest, the sooner you start investing, the greater your long-term earning potential will be. Because most federal loans are low-interest (the current rate is 4.29 percent for undergraduates), retirement funds offer a greater return on investment. Make the minimum payments on your loans and put your extra dollars toward retirement.
The exception is if you have private or other high-interest loans. U.S. News suggests that if your interest rates are over 6 percent, you're better served paying off those loans first. With multiple loans, pay the highest-interest loans first.
If you have any credit card debt, paying it off should be your top financial priority, since the average interest rate right now is about 15 percent. These high rates will offset the returns you could make on almost any investment.
Finally, if your workplace offers a 401(k) employer match, always make the maximum contribution. It's basically free money.
Consider refinancing your loans
High-interest loans or aggressive payment schedules can keep you from starting your retirement nest egg. Refinancing is negotiating a new loan at a lower interest rate or with extended payments, typically after a debtor's credit score rises.
Refinancing can be a good option, but Rohit Chopra warns in a Consumer Financial Protection Bureau blog post of some stipulations.
First, refinancing requires an excellent credit rating, so it probably isn't an option for those who are struggling to make their payments due to underemployment.
Second, refinancers should pay careful attention to their ARP. A lower monthly payment might mean a higher interest rate, leading to more money paid overall.
Finally, pay attention to tax and other benefits. If your new loan is not considered a student loan, you lose the right to claim your loan as an interest tax deduction, along with other government benefits such as income-based repayment.
Look for high-return investments
Despite seeming obvious, this is a principle that eludes many young investors. High return entails greater risk, and some young people want to establish themselves financially before taking a gamble on the market.
In reality, young people are in the best position to make higher-risk investments because if the market dips, they still have plenty of time to make a recovery before retirement.
Bear in mind, however, that there is a difference between high-return investments and speculation. Investopedia equates speculation to gambling — in other words, buying stock simply because it has a chance to go up in value.
Investopedia instead recommends that young people invest in a diversified portfolio of small-cap growth stocks that have high potential in the long term.
Most 401(k) offerings come with packages of stocks with various risk/return ratings so investors can choose a strategy that best fits their needs.