Pay off Your Student Loans

The following is a guest post from Don at MoneySmartGuides.com where he posts about personal finance for the average person. Sadly, personal finance isn’t taught in school and many people are confused on the subject. Don is here to help educate everyone in hopes that they reach their personal finance goals!

Whether you read through magazines or listen to personal finance experts, they all say the same thing: there is no rush to pay off your student loans. They will cite reasons such as tax-deductible interest and higher returns on your money by investing. I disagree with both. You should pay off your student loans as quickly as possible. Why? I’ll get to my reasons shortly. First, let me explain why the reasons the “experts” give are misleading.

Expert Reason 1: Tax-Deduction

It is 100% true that you can deduct the interest you pay on your student loans on your tax return. What is misunderstood is how you actually do this. Many people think that they can deduct the entire amount of interest paid, up to $2,500. This is not entirely true. What you are able to deduct is a percentage that is equal to your income tax rate. For example, if you paid $1,000 in student loan interest last year, you did not deduct $1,000 from your income. You deducted the percentage that equals your tax rate. If you are in the 25% tax bracket, you can deduct $0.25 for every $1.00 in interest you pay. From that $1,000 in interest you paid, you only deducted $250 from your taxes. In other words, you spent $1,000 and saved $250.

Because of this, it is not worth it to take your time paying off the loans. Even though you get to deduct $250 as cited above, you are still losing out on $750 that you paid in interest! By paying off your loans quickly, you will reduce the overall interest that you pay.

Additionally, as your income rises, you get phased out of the deduction. Currently, if you are single and your modified adjusted gross income (MAGI) is between $60-$75K, you cannot deduct the full $2,500. If you earn more than $75,000 you don’t get the deduction at all. For those married filing jointly, the phase-out is between $120-$150K.

Expert Reason 2: Higher Return Through Investing

The second reason given is that you can earn a higher return by investing in the stock market. Before I continue let me be clear: I am not against investing in the stock market. In fact, I am all for it. You should be contributing to your 401(k) at work and/or through a Roth IRA as well. But in this case, with the extra money you have left over at the end of the month, I am against investing it for a couple of reasons. The first is because student loan interest rates are 6.8%. With an interest rate at this level, you are better off paying the loan off as opposed to investing.

Experts will make the case that you can earn a higher return by investing. This is true. Historically, the stock market has returned 8% annually. But with such a small spread on returns, we need to look at an example to see if paying off your loans quickly is the correct choice.

Let us assume you have $20,000 in student loans at 6.8% and a minimum monthly payment of $230. You have to repay the loans back in 10 years. You can either pay them off as quickly as possible and then start investing, or you can pay the minimum and invest any remaining cash, in this case, $100.

  • If you pay the minimum ($230) plus $100 extra per month, you will pay off the loans in just over six years and will pay roughly $4,500 in interest.
  • If you simply pay the minimum, $230, you will pay off the loans in 10 years and will pay roughly $7,600 in interest.
  • Had you taken the extra $100 and invested it for 10 years and earned 8% per year instead of paying extra to your loans, you would have over $18,000.
  • What if you paid the loans off in six years per above and then invested $330 per month for the next four years at 8%? You would have $18,500.

Looking at this, you are better off paying off your loans as soon as possible and then investing that amount in the stock market.

More Reasons to Pay Off Student Loans Early

Here are more reasons for why I feel the way I do. The estimate that the market returns 8% annually is a historical average. Over the past 10 years (2000-2010) the stock market was basically flat, returning just under 1%. In this case, had you invested in the market, you would still have your initial investment and hardly anything more. You could have used that money to pay off your student loans and received a better return on your money.

Another reason is that debt counts against you. If you have large student loan debt, it is going to factor in to how much of a house you can buy. If you have a high monthly payment, it is going to affect your monthly budget in terms of savings.

Most of all, it is going to affect your life in ways you haven’t even thought of before. You are young. You have your whole life ahead of you. What if you get the travel bug in five years and want to quit your job and travel the world? If you are still paying your student loans you will have a difficult time traveling and making those payments. You can always defer the payments, but when you come back, your balance is higher because interest was still accruing. Plus, you have to deal with paying off your student loans into your 40’s. What about starting a family? That monthly student loan payment will cut into the family budget. The point I am trying to make is that you don’t know what lies ahead for you. Don’t let the things you can control and take care of now find ways to drag out further into your life. It’s not worth it financially or emotionally.

30 Responses to Pay off Your Student Loans

  1. Emily Hunter says:

    When I paid off the student loan, it was like the heavens opened up and the angels started to sing. I’d been dodging that bill for nearly 20 years, and it felt great to rid myself of it once and for all.

    • I feel the same way. For a long time after graduating, I only paid the minimum, buying into the idea of the benefit of the interest being tax deductible. As years went by and I wanted to buy a house and travel, those pesky loans I had been putting off were coming back to bite me! I decided enough was enough and worked hard to get rid of them once and for all.

  2. I think expert reason #2 only applies if the interest on your student loans exceeds a certain threshold (set by the individual). We have about $70k in student loan interest, but the rate is only at 2.125%. I think there is a strong case that the market will return higher than 2.125% over time.

    We can’t deduct our student loan interest from taxes because our income exceeds the threshold.

  3. That is a great rate!! Currently, loan rates are 6.8% so for the majority of people graduating now, it makes sense to work at paying off the loans now as opposed to later.

    I do agree that with such a low rate, paying them off maybe is not a priority, especially if you have other higher interest debt.

  4. Michelle says:

    I can’t wait until my loans are gone. The extra money every month will be nice.

  5. What do you think about when subsidized loans are in deferment i.e. 0% interest? Pay off early or invest until they come due?

    • When I had my loans in deferment, I would make the monthly payment to myself. I set up a separate savings account and just let the money accumulate. Then when the deferment ended, I would make a big payment with all of the money in the account. Of course, this was years ago when online savings accounts were yielding 4%. Now, it doesn’t really matter since savings rates are under 1%.

      • Once we saved up all the money, we invested it – some in CDs, some in mutual funds. It’s sort of an experiment. Definitely if we could get 4% in a money market or something we would have done that!

  6. I agree in most instances it makes sense to pay off loans as quickly as possible. However, there are some loan forgiveness programs where it makes sense to minimize your monthly loan payments now to maximize your loan forgiveness. I wrote a guest post about this that will go live in the next couple days on another blog.

  7. I’ve been paying off my student loan for almost 4 years now. I have managed to pay more than half, but I still have lots to go. I can’t wait until I don’t have to send in a monthly payment anymore! I’m all for paying off the student loan as soon as humanly possible. It get’s harder to do as you build a family…

    • Great job on paying off half of your loan. Having that payment does interfere with life as you get older. That is why I suggest to pay them off quickly. Free up all of the money you can for saving for a house, building a retirement fund, or starting a family.

  8. Nice explanation on the tax deductions! My deferral period ends in about 8 months, so that stinks. I have already started making payments, and my work has paid some as well. I plan on having them paid off ASAP!

  9. I agree with #2 on the fact that a student loan is not the same as a mortgage. A mortgage at 4% or less is a good debt to hold for the liquidity because you have an asset against it and that is a historically low rate. A student loan is just that…a loan that should be retired as soon as possible in my opinion. Great post!

  10. Money Infant says:

    My loans are also at a very low rate (2.875%) so I’ve been paying the minimum and will continue to do so. Plus I am not 1% so I still get the tax deduction :)

    If the rate was 6.8% though I would definitely have put the student loans on the must be paid list.

  11. Nick says:

    My loans are at 2.5% and I’m not eligible for the deduction (not yet in the 1% though… soon enough). We’re looking to buy a house soon, so while we have the money to pay them off we’re going to use the money for a bigger down payment which will be at a higher rate (even after deductions, although it’s closer) and because mortgage debt is not forgiven upon death. If I die, the loans go away…

    I also have a monster HELOC on investment property at 8.75% (with a buddy) so that’s a priority, too. Once we’re rocking those though we’ll probably just pound down the student loans.

  12. Jon Rhodes says:

    Interesting post. I’ve always followed the herd and thought it doesn’t matter about paying it off quickly. However I have to admit that even though it only increases with inflation, the figure can rise quite a bit. I would say though that there is no point paying it off early if you have other debts, as they are likely to have a far higher interest rate. However if you are in the clear and have the cash, then why not.

  13. Son of a B! i didn’t know that about the partial deduction on student loan interest. So good to know! Do you have a link to which IRS publication has the exact info Don?

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