In the next week, many American millennials will receive their only cash windfall this year: a tax refund. The average refund last year was about $3,000. For the typical millennial, who earns around $31,000, it’s a rare opportunity to get on firm financial footing.
When you come into a bit of money, you’ve got three options—spend it, save/invest it, or pay down some debt. Conventional wisdom is to always pay off debt first, especially if your interest rate is higher than what you’d earn saving it. Paying off debt instead of saving may be great advice if you have full job security and predictable income. But for everyone else, paying off debt is actually a risky choice. Believe it or not, regardless of your age and income bracket, you might be better off putting that money in the stock market.
First, consider debt as negative saving. The longer you have it, the bigger it grows, especially if you pay high interest rates. As such, in a simple world, paying down debt first makes sense. If you pay 5% interest on your student loans, paying off that debt is sort of like getting a 5% return on your investment—which in this volatile, low interest rate market is a pretty great return. But we don’t live in a simple world.
Most holders of student debt, especially millennials, have volatile incomes. Research based on millions of Social Security records shows younger people’s income is more variable year to year. You face a higher risk of being laid off early in your career and, especially if you work as a freelancer, have no job security or predictable pay. Paying rent, eating, and making debt payments consistently requires savings to smooth out the loss of a job or a pay cut. If you pay off a chunk of your student loans, you might get a bigger-risk adjusted return. But you lose something potentially more valuable: liquidity.
When it comes to debt, the biggest risk you face is defaulting on a payment and destroying your credit. And the people most in danger of that happening tend to be low-earners who didn’t finish a four-year degree and have less than $5,000 in debt. As such, economist Sue Dynarski argues that low, volatile earnings is the problem, not high debt levels. The best thing we can do is give at-risk borrowers more time to pay-off their debt.
This is precisely why it makes more sense to save and invest your refund at a young age rather than paying down debt with it. Suppose you have $10,000 in student debt and pay $200 a month to service it. If you get a $2,000 tax refund, it could certainly make a dent in your debt-level. But that’s also 10 debt payments you can still make if you lose your job in the future.
The save-and-don’t-pay-down debt advice only holds for low interest debt, below 7 or 8% interest, like most student loans or mortgage debt. Paying down your credit card debt is always a smart idea because the interest payments are absurdly high, and (though it is not advised) unused credit is a source of emergency funds.
Whether or not you should put that money in the stock-market depends on how comfortable you are with risk and how certain your job is. Keeping your money in the bank ensures it’s there when you need it. And if there’s a good chance you’ll need the money within the next year, you’re better off in cash. Otherwise, a diversified index fund of stocks offers a real chance for growth.
But no matter how you invest your money, if you need savings, the riskiest thing you can do is pay off your debt.