Student loans, like all forms of debt, have either a fixed or variable interest rate that compounds every month. By making regular payments, you are spending your hard-earned dollars on interest charges and barely tackling the principal.
It is strongly recommended that you use as few student loans as possible to fund your college experience. However, few loans are a reality for few people: College tuition and living expenses have increased well above the inflation rate for the last 20 years, making it nearly impossible to cover everything with the standard Pell Grant and some scholarships.
When your college experience is over, it will be time to pay off your student loans. We’ve put together some tips to help you decide whether or not to prioritize your student loans over other debts and outlined the potential investment gains.
During the COVID-19 Global Pandemic
The global pandemic COVID-19 has drastically changed the landscape of 2020; as of March 13, 2020, the interest on federal student loans has been reduced to 0% for at least the next 60 days. Additionally, borrowers have the option to suspend their payments for two months.
During this time, should you choose to continue payments, the full amount of your payment will be applied to your principal (once all interest accrued prior to the March 13, 2020, announcement was made), allowing you to pay down your balance more quickly while saving some money long-term.
If you have Federal Family Education Loan Program and Federal Perkins loans that are not owned by the U.S. Department of Education, they, along with private loans, are not eligible for the 0% interest rate waiver. However, if you have loans that are eligible for consolidation, they might be eligible for the 0% interest rate waiver. At that point, you’d be able to pay them off quicker. It is important to note, however, that after the rate waver ends, your interest rate might be higher than your current interest rate, and any outstanding interest will capitalize (be added to your principal balance). The best way to determine if loan consolidation is right for you is by contacting your loan servicer.
Saving Money on Interest
Take a moment to look at your student loans. One of the first things that should pop out to you is the interest rate. Divide that number by 12 and multiply it with your current principal. The total number is how much, per month, you are paying in interest. By prioritizing paying off your student loans, you will be saving that amount every month.
It is important to understand that in certain cases, the interest is tax-deductible. However, the maximum amount you can deduct from your taxable income is only $2,500. And even that won’t save you much money, especially if your tax bracket is around the 22% or 24% mark. Assuming you receive the maximum deduction and are in the 24% tax category, you will be saving just $625.
Another factor to consider is the “current cost” of the loan – specifically, how much interest it will cost you to continue paying down the debt at the regular rate. Every dollar you spend right now to lower your total debt will save you a large amount over the life of the loan, though it will keep you from being able to spend the money now on other things.
As such, saving money on interest should only be prioritized after you have enough money in the bank to weather a financial emergency (medical care, car repairs, job loss, etc.).
Paying Off Higher-Interest Debt First
Should you prioritize student loans over other types of debt? The answer to this question depends on how much interest is associated with each form of debt, and whether you have the ability to stick to a financial management plan.
If you are looking to quickly bring down your average interest rate, then tackle the debt with the highest interest rate first. For instance, say you have $10,000 in credit card debt at a 24% interest rate and $30,000 in student loan debt at 6%.
Every month, the credit card debt is collecting roughly $200 in interest and your student loans are incurring roughly $150. So, if you focus on paying off the credit card debt first while making the minimum payment on the student loans, you will be on track to free up $200 per month (and the principal on each monthly payment) to put toward your student loans.
This is known as the “avalanche” method, which is used by people all over the world to maximize their savings by paying off high-interest debt first.
Keep in mind that even if you are not paying off your student loans first, you are still going to save money in the long run by doing this. For instance, assuming you only pay off 4% of your credit card balance every month, you will end up spending $9,774.89 in interest. However, if you pay off 10% of the card balance, you will only spend $2,481.48 in interest, for a total savings of $7,293.41. That money can be used to pay down your student loan debt faster or to invest in a higher-performing investment account.
We recommend using this method to pay off debt when you have a variety of different notes or interest-bearing financial instruments. However, it is important that you maintain enough savings to protect yourself in the event of an unexpected emergency. After all, the last thing you want to do is rack up more debt right after paying off a sizable chunk.
Will the Market Provide a Better Return?
Every penny you save in interest is a return on investment that is directly proportional to the interest rate of the loan. Meaning, if you pay an extra $100 on a student loan with 6%, you will see a “return” of approximately $6 over the next year.
Keep this in mind when determining whether to simply invest your spare cash in stocks, a money market account, or even old-fashioned certificates of deposit. Compare the projected interest rate and to the student loan rate: If the interest rate is higher on the student loan than the investment product, you will be “earning” more money by paying down the debt than by investing it.
However, when the projected interest rate is higher for the investment product than the student loan, don’t simply assume it is a better deal. It is wise to factor in inflation to see whether or not you will still be “losing” money by investing.
Assuming that the inflation rate is 2%, which is right below the average rate we experienced over the last decade, do the following calculation:
(interest rate of investment) – (interest rate on note) – (inflation rate)
Assuming your student loan rate is 6% and your return on investment is 7%, the total will be 7-6-2, for a total of -1%. Compared with the ROI associated with paying off your student loans first – 6-2, or 4% – it’s obvious that the better deal would be to “invest” in paying down your student loans.
This calculation will change as market forces change, so we recommend that you take the time to regularly compare the expected rate of return to see what the best option will be at that particular time.
Using Emergency Savings to Pay Off Loan
We strongly recommend that all students and graduates strive to maintain a healthy emergency savings fund to get them through tough times. As such, we strongly believe that using funds better off in a savings account (for true same-day emergencies) or in a readily liquidated investment product with an interest rate above inflation (for those you have a couple of days before having to pay the bill) is a poor decision that may cost you dearly in the long term.
Using emergency savings to pay down debt is usually a mistake, though many people do it anyway. Take some time to consider the following before deciding whether or not to use your emergency savings to save a bit on interest:
- How long will it take to rebuild the savings?
- Do you have any projected cash bonuses or gifts that can replace the savings?
- Is your financial situation stable enough to weather a shock without savings?
- Are you willing to pay more in interest if you are forced to borrow money to cover an emergency?
Learn More About Student Loans with CollegeFinance
Figuring out the path to financial success shouldn’t be a headache. At CollegeFinance, our team believes you should have access to all the information you need to make well-informed financial decisions. Our team has been exactly where you are now: Approaching graduation and trying to figure everything out without running up a large amount of debt.
It is our mission to help you understand every step of the process, from the right way to fill out the FAFSA to determining whether you should take all of the loans available to you. Join us today and see how a few minutes of your time can help you set yourself up for future financial success.