Stupid Retirement Advice to Avoid if You Have Student Loan Debt

by Repayable | Sep 19, 2016 | Mindset, Money Matters

You’ve heard a lot about saving for retirement. Terms like compounding interest, 401K, IRA get tossed at you on the daily.

But let’s get real, a lot of the advice is garbage once you start to look at it in light of massive amounts of student loan debt.

It’s all half-baked advice from people who never had student loan debt. Let me expose the most common piece of half-witted advice so you can find the piece of truth that applies to you.

The folks giving you this advice aren’t stupid, they’re usually quite financially literate. They typically want the best for you and think they’re giving you rock solid advice. The fact of the matter is what used to work isn’t going to work in the era of crushing student loan debt.

You’ve got to put everything you can into your 401K because you get compounding interest.

What’s the big deal about compounding interest? Well, it’s awesome. Let’s say you put $1000 in your 401K, you make 1% interest so now you have $1010. That means next year you even if you don’t contribute and you earn 1% you’ll make $10.10 instead of the $10.

Ok so you can see with that small amount of money compounding interest isn’t super sexy. But if you have enough money and enough interest you can stop contributing and the interest will continue to build off itself. This is why the saying “the rich get richer” is so true. When you have enough money invested you can withdraw some money and still see your money grow (FYI this is the actual goal of retirement so you never run out of money).

Therein lies the first hole of the argument for throwing everything you can at a 401K. When you’re throwing peanuts in, the compounding interest isn’t doing you a ton of favors. If you had nothing else to spend your money on that might make sense, but remember you have lots of student debt.

Compounding interest works on your student loan debt too. When your federal loans are sitting around earning a pretty 6.7% that compounds on itself too. If you can’t keep up with your interest payments your loan amount will continue to exponentially increase. This is how people get into trouble with credit card debt.

The more you can pay on your loans the lower the principle and the less interest you’ll pay. Essentially it’s the inverse of compounding interest. Perhaps I should call it decelerating debt.

So what’s a financially savvy debt-strapped millennial to do?

Contribute only enough to your 401K to get your employer match. Do not contribute above that amount until your debt is paid off.

You won’t hear this advice anywhere else. People are illogical and will advise you to seek out the compounding interest of the 401K without acknowledging the impact of the compounding interest of your student loan debt. Let me break it down.

Why should you contribute to a 401K at all?

1. You want to retire some day.
2. Employer match money is free money.
3. Match money doesn’t depend on the stock market.

Why not contribute extra to your 401K?

1. You are not guaranteed a positive performance out of your 401K. In 2015 I got a 0.75% return, a colleague got a negative return -0.47% aka he lost money.
2. You are guaranteed to earn interest on your student loans at your prescribed rate (6.7%)
3. Assuming your debt and 401K have the same rate of return your student loan amount is probably higher than the amount in your 401K. Now  you have a dichotomy where the total dollar amount of interest for your debt is more than the total dollar amount of “interest” (aka rate of return) of your 401K.
   1. That looks like this: $100,000 in student loan debt at 6.7% vs $10,000 in 401K at 6.7% rate of return.
      1. Student loan debt -$6,700 401 K +$670 net amount on the year -$6,030 … ouch!

The Retirement Advice You Need to Listen To

Contribute enough money to your 401K to get your employer’s match. Pay the rest to student loans.

• If you can’t afford to contribute enough to get the entire match contribute 1% of  your total income to get yourself in the habit of contributing while still getting some of their match.

If you don’t have an employer sponsored 401K option open up an IRA. Again aim to contribute 1 % of your income to this to build the habit. You’re not leaving anyone’s money on the table so you will be better served by aggressively repaying your debt.

If the amount of money in your retirement account is equal to the amount of money you have in student loan debt consider your options carefully. It is my opinion that you will be better served by eliminating debt. However mathematically this is tough to objectively quantify. Here are some things to keep in mind.

If you eliminate debt early:

• You can focus on contributing to retirment and contribute maximal amounts of income
• You have the opportunity to find additional sources of investment which diversify your financial portfolio and develop yet another income stream

If you contribute aggressively to your retirement:

• Early investment maximizes the potential for your interest to compound which means contributions made early on have more impact than those made later

Retirement seems like a worry for your future self to deal with but it’s something you need to develop a strategy for today. There are many individual factors that play into retirement including the amount of student loan debt you have and the interest rate on that debt.

There are many ways to look at issues of finance and unfortunately these have not yet been tailored to the needs of our millennial generation. I hope this post shed a light on the impact student loan debt interest has on the ideal strategy for retirement.

The advice I gave in this article is pretty unconventional. I would love to hear your thoughts, what you agree or disagree with in the comments below or in the Millennial Maxims Facebook Group.