This post was written by Nathan from LendEDU. He approached me on writing an article that talked about how he tackles this question about whether to pay off your student loans early or not.
I’ve struggled with a similar question in regards to our mortgage. At this point, we’ve decided to not pay off our mortgage early, but I respect and understand where Nate is coming from. In the case of student loans, I would be tempted to get rid of them ASAP.
It’s a tough decision, and Nate walks through his thought process. I want to be clear that this was not a sponsored post, and I found his thoughts insightful.
I do think Nate’s perspective is the safest option. He is guaranteed to save 4% paying off his student loans. And when he does pay them off, he is going to feel on top of the world. I was happy to see that he is contributing some money to his 401K, as this money will grow with more time.
Setting financial goals is important, but it’s also essential to prioritize different goals since there’s only so much money to go around.
Prioritizing goals can be especially challenging when you have student loans, as getting out of debt may seem like a major priority – even when there are other things to do with money, such as investing in the stock market.
The decision of whether to invest or save is one I’ve personally grappled with. I have around $28,000 in student loan debt left to repay and my loans are at an average interest rate of 4%. This is a very low rate – so low that it’s likely I could earn a better return by investing in the stock market. Yet, despite the fact it might make more financial sense to invest, I feel obligated to pay off my student loans ASAP.
I don’t think I’m alone in prioritizing debt repayment over investing, even if the math may not make sense. If you’re struggling with the same decision, here are some of the details on how I’ve made my choice – along with the key considerations you may want to think about when you’re figuring out what to do with your own cash.
The Pros of Paying off Student Loans Early
There are some definite advantages to focusing on early debt payoff that I considered — and that is part of the reason I’ve chosen to focus on aggressively paying down my student loans. Some of those advantages include the following:
- Saving on interest
Although my loans are at only around 4% after refinancing, some student loans have much higher interest rates – especially if you have private student loans, which I do. Plus, even when loans are at a low rate, you can still incur substantial interest when paying them off over a decade or longer.
With my $28,000 in student loans at an average rate of 4%, I would end up paying over $6,000 in total interest if I took a decade to pay off what I owe. That’s a lot of money. And, while some people can take a tax deduction for up to $2,500 in student loan interest, I’m not eligible for this deduction so I get no tax break to offset my interest cost.
If your loans are at a variable rate, it may make even more sense to focus aggressively on repaying student loans because your rate could go up – but this isn’t my situation.
- Freeing up spare cash
As long as you’re in debt, you have a monthly obligation to fulfill and some of your money is promised to a lender even before you earn it. By paying off loans early, you free up this cash to do other things with – so can invest more aggressively later or have more money to do things such as saving for a home down payment when you get ready to buy a house.
I don’t want to have my money promised to a lender and see that cash go out of my bank account every month for a decade – I’d rather fulfill my obligations ASAP so I’ll have more money and freedom in the future to do the things I want.
- Guaranteed return on investment
When you pay off student loans, you get guaranteed interest savings – and your return on investment is equal to the amount you save. While you probably could earn a higher return on investment by putting your money into the stock market, the operative word there is probably. There’s never any guarantee investments will go up.
It’s true if you buy a diversified pool of investments – which you can do easily by investing in index funds – you’re likely to see your investment balance go up over the long-term. But, there could be downturns during which temporary losses occur.
I like knowing that I am definitely saving on the interest I’d have paid on my loans, whereas any investment returns I’m foregoing are speculative.
- Reducing your debt-to-income ratio
Having a lot of student loan debt affects your debt-to-income ratio, which is the amount of money owed relative to income. Many lenders look at debt-to-income when deciding if you’re a high-risk or low-risk borrower. In fact, having a DTI ratio that is too high could disqualify you from getting a mortgage loan or even a car loan.
Paying down student loan debt early reduces the total balance owed. With less outstanding debt, you’re more likely to qualify to borrow for other reasons if necessary.
I like knowing that if I want to buy a home or get a car loan, my debt balance will be lower so I’ll be a more attractive candidate to lenders.
- Psychological benefits
Being debt free is a goal that many people strive for – including me. When you’re debt-free, you have far fewer financial worries because you don’t have an obligation to your lender hanging over your head that you always have to fulfill even if something happens to your income.
Read More: How Credit Card Debt Makes You Miserable
I don’t like knowing that I have this debt that I’ll be responsible for paying every month no matter what. I’m very motivated to get rid of the debt – which makes me work harder to save and make extra payments. I don’t have the same intense motivation to aggressively invest, so I feel like I’m better off working really hard to pay off the debt since that goal drives me to make the most responsible financial decisions.
The Cons of Paying Off Student Loans Early
While I think I’ve explained some of the big benefits of paying off student loans early, there are also downsides that are worth pointing out – and that I’ve definitely considered. Some of the downsides include the following.
- Opportunity cost
Any extra money I pay towards my student loans is money I can’t invest. And, as already mentioned, you can likely earn more by investing in the market than you can earn by paying down low-interest student loans.
The average return for the S&P is around 10% annually when looking back to its inception since 1926. When looking back to 1957 when 500 stocks were added to the S&P, historical average returns are around 8%.
Read More: Can you really beat the stock market?
If you could expect to earn about 8% per year by investing in index funds that track the S&P 500 and student loan interest is at 4%, you forego about 4% per year in gains on any extra money you pay towards student loans instead of investing.
Let’s say you owe $28,000, like me, and your student loan interest rate is at 4%. Monthly payments to repay the loan over a standard 10-year repayment schedule would be about $280. And, as mentioned above, total interest costs over 10 years would be over $6,000 (about $6,160 to be exact).
If you pay an extra $250 a month to student loans – almost doubling your payment – you’d be debt free in 58 months or 4.8 years and total interest costs would be just $2,740. This would save $3,420 in interest. While this may sound good, investing that $250 per month over five years and earning an 8% rate of return would give you just over $18,000 in savings – which is $14,580 more money than the $3,420 you saved in interest.
Obviously, by putting extra money towards loans instead of savings, you’re missing out on a major opportunity.
- Lost tax deductions
Depending on your situation, putting extra money towards student loans could also mean foregoing valuable tax breaks that are available for investing in a 401(k) or IRA.
Contributions to a 401(k) are made with pre-tax dollars, and contributions to an IRA are tax deductible provided your income is below a certain level (or, in all circumstances if neither you nor your spouse has a workplace retirement plan). If you’re not maxing out your 401(k) or IRA because you’re paying extra to student loans, you’re giving up a valuable tax break.
Take the above example where you pay $250 extra per month to student loans. If you invested that money instead in a 401(k), you could take a $3,000 tax deduction. If you were taxed at 22%, you’d save $660. You miss out on that savings by not maxing out your 401(k).
I’m actually guilty of this, as I’m not maxing out my tax-deductible contributions. While I’m contributing about 6% of my income to my 401(k), I’m not hitting the contribution limit and I should divert more of my spare cash towards reaching that limit and less to student loan repayment. But, I probably won’t because, for me, the psychological pull of paying off my student debt is just too strong.
Making the Right Choice on Whether to Pay off Student Loans Early
When it comes to deciding whether to invest or pay off student loans, the math is clear – investing likely makes more sense, even though you do take a risk whereas paying off student loans is a guaranteed return on investment.
However, financial decisions aren’t always about the math. There’s a lot of psychology behind how we handle our money and, if you’re much more motivated to pay off student loans – and will work harder to do it faster than you would to invest a whole bunch of cash – doing so may be the right choice for you.
For me, I’ll stick with sending extra money towards my student loans. I hope to get that debt paid off ASAP and then with my freed-up cash, will be able to do all the other things I want – like maxing out my 401(k).
Nate is a twenty-something working to repaying a meaningful student loan balance. Nate is the co-founder of a personal finance site called LendEDU, which was originally launched to help college students better manage their student loans.