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.