Student Loans and the Hierarchy of Savings
- Investments“What’s the best way to pay off my student loans? How should I prioritize them against my other goals?” These are common questions for younger people, who have many competing priorities for each dollar they earn. Read on for some perspective about where student debt falls in the hierarchy.
There are probably more Hierarchy of Savings models out there than I could shake the proverbial stick at. Here’s the general idea: while you’re still accumulating savings (not retired), there is a recommended order in which you should save extra money. Here is one model, in order of priority:
1. Emergency reserve: you probably want to keep enough cash on hand to fund 3 – 6 months of expenses. That number can vary a lot depending on the security of your job, how much you would get paid if you got laid off (if anything), and how much you like your job. If you hate your job, maybe you want to have 18 months of expenses on hand so you can quit and search for another job or launch your own gig. And yes, keep this money in cash. You don’t want to have to sell a mutual fund at the wrong time just to pay for a new refrigerator.
2. Leverage the match: next, invest at least enough in your 401(k) or 403(b) to get your employer’s match. If you have a Health-Savings Account (HSA) available to you at work, save there, too. These employer matches are all free money for you!
3. Pay off debt: in general, pay off the debt with the highest interest rate first. This is where you’ll focus on student loans, credit cards, and any other debt. Home loans may be the exception here: if you wait until the house is paid off to save for retirement, you might not make it. In general, it’s OK for most people to keep paying the mortgage as agreed and proceed to the next step.
4. Regular or Roth IRA: if you are under the income limit for contributing to an IRA, max that next. If you’re over the IRA income limit or have maxed your IRA, max contributions your Roth IRA next. Don’t forget that Roth IRAs have income limits, too; this means that you might make too much money to contribute, so be sure to check the current year’s income limits online.
5. Max tax-deferred contributions: next, max your contributions to your 401(k) or 403(b), make Roth contributions to your 401(k) and 403(b) if you can, and contribute to your Deferred Compensation program if you have one. If you’re self-employed or own a small company, this is where you do a SEP IRA, SIMPLE IRA, or Personal K.
6. Tax-deferred annuity or life insurance: next, you can still get tax-deferred growth on the money you’re saving within an annuity or life insurance. But only buy the life insurance if you need it! To get a general idea of whether you need life insurance, read this post.
7. Taxable savings: when you’ve exhausted all other avenues and still want to save more, you can invest in a regular, taxable account. I said “invest” for a reason: this money should be invested in line with your overall strategy, not in gold or cash or Bitcoin. This account should be carefully tax-managed by you or the people managing the account, meaning that the manager is working to minimize capital gains tax along the way. You want to keep more of that money in your pocket so it can grow for you!
These guidelines won’t fit everyone perfectly, and your particular situation may change their order. For example, some people want to save in 529 college plans for their kids, and this could fall just about anywhere on the list depending on your priorities. See a financial life planner if you need help tailoring the guidelines to your life.
Now what about those student loans? I thought it might be fun to end this post with dueling payoff strategies:
1. Avalanche: this is the strategy I talked about in #3 above. You pay off the loan with the highest rate first and then move on to the loan with the next highest rate, and so on. This minimizes the total interest you will pay.
2. Snowball: you pay off the loan with the smallest balance first, then move to the next highest balance, and so on. This can give you a psychological boost, since you will gain momentum by paying off some loans right away.
If you make decisions by the numbers alone, Avalanche is the way to go. But I don’t discount the power of Snowball, since it can feel really motivating to pay off a loan quickly. You do the one that’s right for you.
And if you’re thinking, “I don’t have any extra to save or pay debt,” please read my post about creating a spending plan.
