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Pay Student Debt or Fund 401(k)? Here's The Easy Answer

Guest blogger Jeffery King is an education blogger and social media expert for StudyMode.com. Since graduating from college, Jeffery has continued to stay involved with educating students about college finances, studying tips, online education technology and more.

New college graduates may find themselves in a bind. They have significant student loans that they would like to pay off, and also have a 401(k) to fund. So what should they do?

The best way to approach this question is to simplify it. For starters, funding a 401(k) is saving money. Paying off student loans is paying off debt. Reframing the question like this makes it easier to answer. Fundamentally, we are asking whether it is better for recent grads to save money or to pay off debt.

Even the simplified version of this question can seem daunting at first, as there is a lot to consider. Thinking about your current budget, your future income, tax consequences, the power of compound interest and the amortization of your student loans is enough to make anyone's head spin.

The Short Answer

Fortunately, there is another way to think about the problem. Instead of having to do the math dollar for dollar to figure out what you should do, consider this: 401(k)s usually earn a higher rate of return than the interest rate payable on student loans. 401(k)s typically grow at a rate of 6-8% per year while student loans carry an average interest rate of 4-5%.

The difference in those interest rates answers the question. The money you save in a 401(k) will grow faster than the debt of your student loans, so it is better to save into your 401(k) than to pay down your student loans.

Of course, the devil is in the details. If the stock market crashes and stays down for 10 years, it will mean your 401(k) will not grow faster than the debt on your student loans. While a stock market crash is possible, most people trust the market to deliver at least modest returns in the short term. This is especially true for long-term investors, like 401(k) holders, who put their money in the market and keep it there for decades.

Another problem may arise if you have especially expensive student loans. If your student loan interest rate is very high, at say, 6 or 8%, then you have a problem. When your student loan interest is high, it has the potential to outgrow your 401(k) earnings. In this case, you do want to pay off your student loans first. 

While a strong stock market return could grow your 401(k) at 10% or more a year, there is no way for you to guarantee that will happen. Smart investors do not hope for miracles. If your student loan interest rate is above the average growth of the market -- in other words, higher than 6 to 8% -- then do the safe thing and pay off your student loans. No one can predict what the market will do.

It's Not All or Nothing

Up until now we have looked at this as an all-or-nothing prospect: Either you throw all your extra money at your 401(k), or you give all your extra money to your student loans.  But it does not have to be that way. In some cases, it shouldn't be that way.

Check if your company matches contributions to 401(k)s. Not every employer does this, but about half of them do (fewer companies match in times of recession). If your employer does match 401(k) contributions, find out how much they match. A 3% match is about average, but some generous companies match up to 6% of 401(k) contributions.

When your company matches 401(k) contributions, it adds a dollar to your 401(k) for every dollar you put in, up to a set percent of your salary. For example, if your employer matches up to 3%, it will match your 401(k) contributions, dollar for dollar, up to 3% of your salary.

This is essentially a 3% raise. Some financial experts refer to it as "free money." Whatever you want to call it, it's significant to your bottom line. It's enough of an incentive that most people should be contributing at up to the amount of a company match, even if it means you have less money available to pay student loans.

401(k) matching is so good that even if you have expensive student loans, you should still invest enough money into your 401(k) to earn the employer matching. The extra money your company is giving you is enough of a bump to change the equation for you. With that extra match, your money is doubled, making your 401(k) contribution a better financial move than paying off your student loans.

Just don't go overboard. Put just enough money into your 401(k) to max out your employer's match, then stop there. Save the rest of your money to pay off those pricey loans.

A Word About Taxes

There are tax consequences to saving into a 401(k) and to paying off student loans. 401(k) contributions come out of pre-tax dollars, so maxing out your 401(k) will reduce your tax bill slightly. Your student loan interest is tax-deductible, so that also helps reduce your tax bill but not by much. Ultimately, there are no strong benefits to either option when your income is low. When you make more than $70,000 a year, then the calculations will generally favor investing in your 401(k) over paying off student loans.

But no matter which option you choose, you should always have an emergency fund saved up first. This can go toward things like unexpected car repairs or medical bills. After all, you can't pay down debt and save for the future if you can't take care of the present.