Last week a friend and I were talking about what to do when you want to pay back your student loans fast, but you also have a 401K that you want to use.

He’s going to be graduating soon and is wondering what to do with his excess cash. Should he use everything he can to pay back his student loan? Or should he contribute to his 401K first and not pay as much on his loan?

It’s a tough question that many of us face.

Since the average student in 2016 graduated with $37,000 worth of student debt, it’s no doubt on many of our minds.

My gut told me that he should first invest in his 401K enough to get the company match. Then use any extra to pay down his student debt faster. After all, you shouldn’t ever turn down free money.

But after our conversation, I wanted to run the numbers for myself, and really see if that’s the best choice.

**Spoiler Alert: it is.*

## Student Debt Sucks – I Know

Before I show you the numbers, I want you to know that I understand the other side.

Debt freaking sucks.

It’s like being chained to a wall while a dog taunts you with the keys from the other side of the jail cell.

It’s not fun and even when you can see a way to get out, it feels like you’ll never reach it.

So lots of people will object. We don’t want to contribute to our 401K because being in debt feels horrible.

Our emotions tell us to throw every spare dollar at our debt. We feel so strained and want to be out so we put on the blinders.

And I get it. If anyone can hop on the emotional money train, it’s me.

I even have an entire article proving that emotional debt pay down is better than mathematical pay down.

But before we start jumping on the emotional bandwagon, let’s do our due diligence and look at the numbers.

## The Math – Scenario 1

For scenario 1 we’re going to assume you have a super low-interest rate on your student loans and an above average stock market return. This is the best case scenario for contributing to your 401K.

Here’s the setup:

- Student loans at 3.5% APR
- Stock market return of 8% APR
- $20,000 worth of student loans
- 10-year repayment plan
- Salary of $50,000 per year
- Savings rate of 20% ($10,000 per year) above expenses
- Employer matches half up to 3% of your 401K*

**This means you need to contribute 6% of your salary to get the full employer match of 3%.*

The first thing to do is determine how long it will take you to pay down your student loans if you contribute all $10,000 every single year.

Because you have such a high savings rate, it only takes you 1.75 years (21 months) to pay down your debt. On top of that, you only pay $618 in interest because you paid it so fast!

Unfortunately, if you contribute 6% of your salary to your 401K it’s going to take you 2.3 years (28 months) to pay them off. And you’ll also end up paying a total of $816 in interest.

Which is $200 more than using all your savings on loans.

But watch this what happens when you contribute 6% to your 401K. This means $3,000 to your 401K and $7,000 to your student loans.

Your employer is automatically going to match half. Which means you get $1,500 for FREE every year. And at an 8% APR, your 401K will be worth $11,500 by the time you pay off your student loans.

Even after you account for the extra interest payment, you still have $11,303 more when you contribute to the 401K!

Clearly, it makes more sense to contribute to your 401K in this scenario. You still pay off your student loans quickly and have an extra $11,303 to show for it!

But I hear what you’re saying.

“Of course it does, you rigged the numbers to work in the 401K’s favor.”

Fine, you’re right. I totally did. The numbers are all in favor of the 401K.

But what happens if we make the numbers bad.

## The Math – Scenario 2

In this scenario, we’re going to put favor on paying down the loans with your extra savings. So we’ll give the loans a super high-interest rate of 7.5% and we’ll say you make -8% in the stock market. You’re actually going to lose money in your investments.

Let’s see what happens now if all of the other numbers remain the same.

So even with an extremely high loan rate and a negative market return, you still end up $9,000 ahead by contributing to the 401K.

Okay, okay, let’s look at one more, just to prove my point.

## The Math – Scenario 3

Just to prove my point, let’s use an interest rate of 10% and a market return of -50%.

That’s right, a stock market **loss of half** your investment annually.

Now let’s see what happens.

Even with a negative 50% return and an interest rate of 10%, the 401K still comes out ahead by $5,687!

## Why This Works

I know this all seems a bit crazy. After all, how can you take a 50% loss on your annual return and still come out ahead?

**The answer: Free money gives you a HUGE return. **

When you contribute enough to get the full employer match, you’re getting a massive return on your investment. In this example, you get a 50% return.

In one year you put in $3,000 and then you get $1,500 from your employer. That’s a positive 50% return.

Even if you get a negative return from the stock market, you still come out ahead because of the massive amount of free money you got from your employer.

Under normal circumstances, if you are comparing an investment and paying off a loan you would compare guaranteed vs. possible.

For example:

You might have a loan with a 5% interest rate and a possible investment with a 6% return. If that’s the case, I would say use your money to pay off the 5% loan because it’s a guaranteed 5% return. On the other hand, the possible 6% investment isn’t guaranteed.

But with your 401K, the free money is **guaranteed!**

The bottom line here is that if you’re ever offered a guaranteed return of 50%, **ALWAYS TAKE IT.**

Even if you give up 7.5% in interest on your loan, that’s still a net gain of 42.5% even before the market return.

But if you still don’t believe me, try some of this out for yourself. Student Loan Hero has a great calculator you can use for free here.

## If You Have A Company Match

You should always contribute enough to get the full amount.

Do this even before paying extra on your student loans.

If you don’t have a company match, then you’ll have to decide if a guaranteed interest rate on your loans is worth it compared to a possible interest rate in the stock market.

But for most people, it’s always going to make sense to use that extra money in this order.

- Pay minimums on student loans
- Contribute to 401K enough to get the full match
- Stop contributing to the 401K once you hit the employer match
- Use additional money to pay extra on student loans

The company match is always worth it.

*If you’d like to learn more super practical ways you can start choosing financial freedom. Sign up for my FREE 5 Lesson Email Course on Choosing Financial Freedom.*

Nate from KC says

To be fair, shouldn’t you start contributing 10% of your income to 401k in month 22 thru 28 just to see what the 401k value would be at the end of 28 months for both scenarios? That would get you a portion of that free money that you’re missing out. Both options should look at the same timeframe IMO.

Nick True says

Holy Crap Nate. You’re totally right. I don’t know how I missed that oversight.

I’m going to re-work my excel sheet on this post and then update it with the new numbers… My gut still says the 401K will win, but it won’t be nearly as big of a margin. Thanks for pointing this out! I don’t know how I missed it.

Nate from KC says

No worries! I’m one of those nerdy engineers with their own spreadsheets that has had to go through many revisions on similar things. I just choose not to blog and show all of my mistakes :)! Keep doing what you’re doing, this stuff is great and your approach to this blog will help a lot of people starting their path!

Nick True says

haha, I appreciate it Nate, thanks for keeping me on my toes 🙂 I’m glad you enjoy the approach of the blog, helping people getting started is definitely the goal!

Also… I’ve re-run the numbers for this article, and I’m hoping to get updated this week. Again, thanks buddy.