Should You Pay Off Your Student Loans With Your Bonus or Invest that Money?

Most lawyers come out of law school with a massive amount of student loan debt. I know my wife and I did.

So, when you get your year-end bonus – or you’ve got a good chunk of cash saved up from your salary – should you invest that money or pay down the principal on your law school loans?

money-trap1-1238807First kudos to you for thinking of it that way. We’ve all heard the stories of lawyers who spent their bonus on a super-fancy vacation or car. Don’t be that guy.

Here’s the case for investing your bonus:

Suppose that student loan debt is at a 3% interest rate. You could likely invest the money and make, say 5% interest. So, if you’ve invested the money, you could choose later to just take the money you earned, use it to pay off the debt, then keep the difference. And, along the way, you’ll have a tidy 2% profit.

This makes sense when you look at the math. A bunch of my friends hired financial planners and got this advice. They even got this advice from financial planners who don’t charge based on the amount of money under management with them, so you know it’s good advice. Or at least rational advice.

To further buttress the case for investing rather than paying off your law school loans, your student loan debt may be deductible, so, by paying it off, you’re basically buying yourself into higher taxes. (or so the argument goes) In effect, the student loan debt is actually at a lower effective interest rate than its actual interest rate. Sadly, if you make too much, the student loan stops being deductible, but nothing’s perfect.

Here’s the case for paying down your law school loan:

First, there are problems with the argument that you should invest the money instead. The return you get on your investments is speculative – it may be that you earn less than your interest. Then you’ve just moved backwards. If you want to be risk averse with getting rid of your student loan debt, then you should make sure you lock in getting rid of your student loan debt.

But the bigger problem I see with telling yourself that you’ll invest the money instead of prepay your debt is that the money will always be there, tempting you to spend it. If you prepay debt, then the debt is paid and you can’t spend the money again. If it’s sitting in an index fund, then you can tap it. It may be for a good reason – like buying a house. Or it may be for a less good reason – like buying a house that’s bigger than you need. Either way, lawyers are pretty good advocates; we know how to present a justification for what we want to do.

If you pay the student loan now, you only need to be disciplined with that chunk of money once. If you put it in index funds, you’ll know it’s there, and the siren call of Vanguard will haunt your ears, whenever the car breaks down, or the baby is about to be born and all of your friends are going on a babymoon, or you’ve just spent more than you earn on credit cards and it doesn’t make sense to pay that massive interest rate.

It’s a question of discipline. Ultimately, I’d worry less about whether the market is reliable than whether I am.

Though, again, if your choices are buy a BMW or put the money in an index fund, obviously, go with the index fund.

How will it feel?

And, of course, all of this is to say that my wife and I just paid off the debt.

It just felt good. The value we got from knowing the student loan debt was gone (or reduced) exceeded the likely benefit we’d get from the marginal difference in return on that money.

It’s nice not to have student loan debt.

2 thoughts on “Should You Pay Off Your Student Loans With Your Bonus or Invest that Money?”

  1. Hey, fellow lawyer/FI blogger here. I appreciate what you’re doing, and I’m looking forward to seeing more lawyer-specific advice!

    That said, I just confronted this decision with my own bonuses (and wedding gifts), and I came to the exact opposite conclusion! Like everything in personal finance, it’s an intensely personal decision, and I’m fairly certain the difference in our conclusions boils down to (1) me being a lowly young associate with a salary that doesn’t enable me to max out pre-tax investments, and (2) a student loan balance that leaves me with too much paid interest that can’t be deducted. You can read about it here, if you like:

    To summarize: I have massive student loans, and my salary is such that I am in the 25% tax bracket but unable to max out all of my pre-tax investments and still cover my expenses. So, I get a substantial immediate return on my pre-tax investments. I also approach my “coast-FI” goal much more rapidly – likely cutting a decade off of my full-time working career, even though I’ll carry my student loan debt for an extra 4-5 years. That immediate return, coupled with the promise of partial-financial independence affording me the opportunity to take risks, makes my decision to invest rather than pay loans very, very easy! So, I have my firm automatically deposit every bonus to whatever account(s) have room left! If I end up filling them all, I’ll bring it home for the tIRA, or for an early payment on my student loan debt if I have no other tax-advantaged accounts available – a great problem I hope to have soon!

    One thing I’d like to add to your post: The student loan interest deduction is capped at $2,500 regardless of your income level. So it’s not like the mortgage deduction that most of us can take full advantage of; rather, I get to deduct about $.06 on the dollar for the interest I pay. When I make a pre-tax investment, I get to deduct about $.25 on the dollar!

    1. I loved your post! Nice analysis.

      I think I kind of assume that hitting your pretax accounts is a given. Which may be an annoyingly privileged thing to assume, I realize. As a guy in my mid-forties, I panic enough about retirement that I’d live really frugally before I wouldn’t max out pretax contributions. Though, as I think about it, even when I was a lowly government lawyer years ago my wife and I maxed out our pretax accounts.

      But, once you’re investing after tax I think it’s a harder call. But I think you’re right that if you haven’t hit your pretax accounts, you should do that before you assault the student loans. Unless you really really hate the debt/anticipate a quick radically reduced lower income.

      And thanks for commenting!

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