Hundreds of thousands of Americans were, until very recently, planning to scrimp and save to spend the next few decades paying off cumbersome loans. Under Biden’s debt plan that equation has shifted, leaving the newly debt-unburdened with some enticing choices—and huge opportunities.
While debates about the macroeconomic effects of federal student loan relief continue on, the financial effect for individuals is clear: Millions of federal student loan borrowers will see their monthly student loan repayments be lowered, disappear completely, or be paid off sooner than anticipated. While it isn’t precisely known when Biden’s debt plan (to cancel $10,000 for individual borrowers making under $125,000, and $20,000 for Pell Grant recipients) will technically go into effect, the student loan pause has been extended until January, so borrowers can formulate a plan based on their new personal finance situation. The debt cancellation means that many borrowers will now have more breathing room to work toward other financial goals. According to Bank of America, the debt relief program will result in a median saving of more than $150 per monthly student loan repayment for impacted households. Especially for younger borrowers, this cash flow can go a long way in terms of building wealth.
If you were assuming you would have to start repaying your loans this fall before Biden’s announcement, figuring out your strategy about where to delegate this unexpected cash influx is the best way make your money go the furthest. “Because student borrowers are already accustomed to this fixed monthly expense, they have a really incredible opportunity to jumpstart their wealth accumulation,” explained Megan Slatter, a wealth advisor at Crewe Advisors. “Now, by simply shifting where this monthly payment goes, they get to stop using it to pay someone else each month, and they get to start using it to pay themselves,” explained Slatter.
Slatter says that an emergency fund is priority number one for anyone with a little breathing room following loan forgiveness. For example, if you are planning to buy a car in a few months or don’t have three to six months of rent money saved, building those savings should be top of mind. “Once you have enough in your satisfied savings account, then it’s really important to start focusing on building that investment account,” Slatter explained.
Marguerita Cheng, a financial advisor at Blue Ocean Global Wealth, agreed, explaining that borrowers who just learned they would receive some debt relief should consider their personal order of priorities when deciding where extra cash should be deposited. Cheng advised borrowers to pay off any high interest debt, like credit card debt, and make sure they have enough cash for emergencies and rent before they invest in the stock market.
Cheng explained that the best way to begin building wealth for borrowers whose immediate financial needs have been met is to put extra cash in a retirement account. Cheng advised borrowers to open a 401(k) account and fully utilize their employer 401(k) match if their job offers one to employees. If you don’t have a 401k match from your employer, another great option to start building wealth is a Roth IRA account. The benefit of a Roth IRA is that the money is taxed when it’s deposited into the account as opposed to when it’s taken out, so the money can grow in the account tax-free. “Everybody can benefit from some tax-free accounts, but particularly younger people because they’re going to be in the market longer,” Cheng explained.
The math is striking: Take a 25-year-old who in 2019 was putting $200 a month toward loans. If they instead contribute that amount to a Roth IRA beginning now, the accumulated savings would amount to $512,663 by the time they retire at 65. While most borrowers have not paid off their loans completely, those who may have monthly payments reduced based on their loan cancellations or the income-driven repayment plan still have the power of compounding interest on their side if they put even smaller monthly amounts into a retirement account.
Choosing to invest is important, but so is choosing where to invest. Slatter suggests starting with low-cost exchange-traded funds and index funds. Index funds are a great way to start investing because they are comprised of a group of securities that can include stocks, bonds, and assets that aim to track one specific index, so they are hands off and lower risk compared to investing in one stock. While mutual funds are usually managed by a professional and include a broad range of investment funds, index funds are a bundle of securities that usually track one market index, most often the the S&P 500 or Dow Jones Industrial Average.
Slatter emphasized that consistently investing in the market is more important than the specific sector or fund for investors that may still be building their portfolio. “Focus on getting exposure to the S&P 500 as opposed to focusing on individual sectors,” she said. “Really, it’s nothing exciting, it’s just a consistent action by doing the same thing monthly,” Slatter said. For an investor who puts $150 per month in the market every month for the next ten years, their accrued balance will be $27,192 with a rate of 8% annual return.
However, it’s important to consider how much fees will cut into your portfolio’s performance. Every ETF has an expense ratio, which is the cost that the ETF charges for portfolio management and administrative costs, expressed as a percentage of the fund’s net assets. The average expense ratio for a Vanguard ETF is 0.06%; the average passively managed ETF at Charles Schwab is .05%. For an actively managed portfolio such as a mutual fund, a reasonable expense ratio is in the range of .5% to .75%.
Yet it is also important to consider diversifying your investment portfolio beyond just the S&P 500. While the annual return will allow your money to compound over time, to build a more comprehensive and lower-risk portfolio, investors should also consider weighting bonds as about 10% to 20% of their portfolio. Another important aspect is thinking beyond the U.S. economy. Due to the current strength of the dollar and the fact that international industries are rapidly expanding, weighting international equities in your portfolio is a smart move if you want to maximize your long-term gains.
Beyond your 401(k) or IRA, if you have more money to put to work, that’s excellent, but be mindful of taxes. It’s important to make sure you’re choosing ETFs or funds that are tax-efficient, meaning they aren’t buying and selling a lot during the year that will generate big capital-gains tax bills come April. For instance, Vanguard caused many investors headaches this past year with its Target Date Retirement Funds which, when held outside retirement accounts, generated outsized tax bills for many investors. According to the research firm Morningstar, ETFs were the most tax efficient fund in both U.S. and international exposure. Morningstar’s top tax-efficient core ETFs for U.S. exposure were iShares Core S&P 500 ETF 500, iShares Core S&P Total US Stock Market ETF, Schwab U.S. Broad Market, Vanguard S&P 500 , and Vanguard Total Stock Market. For international exposure, the top ETFs included Vanguard FTSE All-World ex-US, Vanguard Total International Stock Market Index, Schwab International Equity ETF, and iShares Core MSCI Total International Stock ETF. Keep in mind that international equities usually have higher taxes due to the fact that international companies often pay higher dividends.
Another option is choosing a tax-managed fund. These funds use tax-loss harvesting to avoid high capital gains taxes. Tax-managed funds also hold stocks for a long period of time to avoid taxes from short-term gains, and they avoid stocks that pay dividends and trigger taxes. Yet these funds are often more expensive because they have to be more closely managed, so they are less accessible for novice investors.
Cheng also added that for borrowers thinking about building a family, life insurance could be a potential worthwhile purchase. “It might not be an investment in a traditional sense, but it’s investing in your peace of mind,” Cheng explained.
Whether it’s an index fund, a retirement account, or paying off debt and saving, making a plan for how you will spend the extra cash can help you achieve long term financial goals. “I would encourage people, whatever that cash flow is, to put it to work for you,” Cheng said.
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