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Paying off student loans early/lump sum — best practices?

I'm curious as to the advantages or disadvantages of paying off student loans early. I understand that interest paid on student loans is tax deductible, but I'm unsure if it's worth the deduction, or it's more beneficial to pay them off quickly. To provide a little background about myself, I'm a mid-20's male, living and graduating from a university in the US, who owes approximately $35,000 in accumulated student loan debt (with a pretty average interest rate of ~6%). I have a full-time job with excellent benefits including long-term and short-term disability if something were to happen to me, I would at least have a bit of a fall back. I have zero debt outside of my student loans (no house, cars, or credit cards). I have about $50,000 in savings, so I could theoretically expunge all debt from my record and officially be debt free in one fell swoop, and still have a moderate emergency stash.

  • Are there advantages to paying off early (in one or a few major lump sums)?
  • Are there disadvantages to paying off early?
  • Would this affect my credit in any way?

Thanks for your help.

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marked as duplicate by littleadv, JoeTaxpayer, Dheer, mhoran_psprep, C. Ross Jan 25 '13 at 18:21

This question has been asked before and already has an answer. If those answers do not fully address your question, please ask a new question.

    
This depends a lot on the country, since many student loans are from governments and have unusual terms. –  MSalters Jan 22 '13 at 10:00
    
@littleadv - I did see this question prior to posting; however, that question seems more concerned with best practices concerned with the act of paying down the student loan. Not specifically advantages or disadvantages of paying off early. Thanks for the comment. –  pbl Jan 22 '13 at 14:38
    
@MSalters - Updated original question. Sorry for omitting that. I'm in the US. –  pbl Jan 22 '13 at 14:40
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@littleadv: I don't think this is a duplicate, since this question is asking for both advantages and disadvantages of paying off the loan early. –  Bruce Alderman Jan 22 '13 at 15:25
    
Look at it in reverse. If you were debt free and had $15K in the bank, would you borrow $35K at 6% and put it in savings? –  Kevin Jan 22 '13 at 23:02

3 Answers 3

Basically, the money you pay in student loan interest is tax deductible, which means as far as the IRS is concerned, you didn't make that money. However, what that saves you on your taxes is a percentage of a percentage; you save the amount of your current marginal rate on the money you paid as interest.

Simple example with made-up numbers: Let's say you had a student loan outstanding, and you were making payments of $150 monthly on it. Total payments to said loan in one tax year would be $1800. Of that amount, let's for the sake of argument say that half, $900, was interest. You get your 1098-E with that number on it, and reduce your taxable income by that amount. You're currently doing well, not outstanding but OK, so you're in the 25% tax bracket that most single middle-classers are in. So, your reduction in taxable income of $900 saves you the 25% that those 900 simoleons would have been taxed at, which is $225. So, all told, this loan is a net drain on your disposable income of $1,575, of which $675 is pure cost of capital; you never received a dollar in disbursements to match this amount you're paying, so it's money lost now in return for previous gains.

10 years later, you pay off the debt. Now that $1800 is yours to keep, and to pay full taxes on. You pay $225 more in taxes (actually, because of amortization, the amount of additional taxes has been steadily increasing as the interest portion of the loan payments has reduced) but have the remaining $1575 in your pocket to do something else.

While there is good debt and bad debt, debt is debt; whether deductible or not, the IRS will never credit your tax bill in the amount of interest owed (AFAIK; if someone knows of a loan whose interest is a credit instead of a deduction I'm all ears). So, the deduction on this loan reduces your cost of capital to an effective APR of 4.5%, and because it's a student loan and not a mortgage, you don't have to itemize so this is in effect a "free" deduction (even with an FHA mortgage allowing me to deduct interest, property taxes and PMI, and the residual medical costs after insurance of having our new baby, the $11,900 standard deduction for my wife and I was still the better deal this year). But, you're still losing 4.5% per year to interest. That's your break-even; if the money you could use to pay your debt could earn a better return than 4.5%, then invest it, but if not, pay off the loan. Right now, investments that could make you 4.5% are at the bottom edge of a steep increase in risk and variance, so if your expected ROI is close, I'd lean toward paying off the debt.

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It's in your interest to pay down these loans (just like any debt) at an accelerated rate, so long as you prioritize it appropriately and don't jeopardize your financial situation.

What are your plans for the $50k? Is it a downpayment on a house? Are you already saving for retirement? At what rate are you saving each year?

These are all important questions. There is nothing wrong with using some of the $50k to make a dent in your loans, but overpaying a debt at 6% should not be your first priority. Save for retirement, pay off credit cards, make sure you have an emergency fund of between 6-12 months living expenses (depending on your comfort level as well as how stable you think your job is, and how much you could downsize if need be). Then, tackle extra loan payments.

Unfortunately 6% is about what you would expect to get in the market these days, so you can't necessarily make more money investing your remaining cash on hand as compared to putting it towards your loans. And you could always make less.

Personally, I would divide the $50k as follows. Insert your own numbers/circumstances :)

  • Reserve $10k for an emergency fund
  • Make sure you are contributing to a retirement plan (if you are not, you could open a Roth IRA and contribute both for the 2012 and 2013 tax years - up to ~$10k total)

Of the ~$30k that remains...

  • Money that I will need within the next 3-5 years goes into CDs or another FDIC insured product
  • Invest half of what's left (your choice of investments... there is plenty of guidance here and on other sites)
  • Take the remainder and stick it in savings. Use this money to make extra payments on your student loans over the next 2-3 years.
  • Re-evaluate each year. Hopefully you will be making more money each year and will be able to contribute more to your savings, investments, retirement accounts, and loan debt.
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Overall, I strongly recommend cashing out your savings and becoming debt free today, and then never borrowing again except for a house.

Advantages:

  • You’ll be able to keep all your future income, which, when you’re young, is by far your largest asset.
  • You’ll have more financial freedom in general. For example, if you want to take a year off work and travel, the ball and chain that is your loan payments could be cost prohibitive.
  • In the short term, your credit rating will improve because of your decreased debt levels.

Disadvantages:

  • Theoretically, you can increase your wealth more quickly by investing it in the stock market at a 10-11% rate of return than you can paying off your debt (at a ~6% rate of return).
  • You get a tax break on the interest you pay (e.g., if you pay $1000 in interest is a year you’ll get about $250 chopped off your tax bill because of the decrease in net income).
  • In the long term, if you don’t borrow any other money, your credit rating will disappear because you have to maintain debt to keep it.

My wife and I paid of all of my grad school debt last year, and we’re paying off all of her grad school debt this year. To pay that aggressively, we’ve had to learn to live on a much tighter budget. But when we’re done, if we simply invest what we have been paying toward debt into the stock market, our nest egg will compound to over $10 million by the time we retire.

According to Dave Ramsey, when the Forbes 400 were polled, 75% of them cited becoming and staying debt-free as the single best way to build wealth: http://www.daveramsey.com/article/three-steps-to-wealth-building-for-young-adults/lifeandmoney_college/text4/

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-1. The biggest disadvantage of all is that once you have paid your loans you cannot get that money back. You are suggesting the OP give up 70% of his asset liquidity - a significant financial risk. Additionally, expecting 10-11% market returns is ludicrous. –  Jeremy Jan 22 '13 at 21:58
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While it's great to be debt-free, you may find this post relevant. I especially like Joe Taxpayer's answer. –  Steven Jan 22 '13 at 22:00
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I'm generally against the "debt-free" preaching as a principle. Everything is good in moderation, ideology included. While 10% ROI is ludicrous as an expectation, it is doable in good years. I've done better in some. The 6% on the loan is tax deductible, which may be 10%, 39.6%, and all in between. Bottom line, everything is relative to the OP's actual situation. –  littleadv Jan 22 '13 at 22:32
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Note that the stock market has risk, whereas the 6% return on paying off the debt is risk free and guaranteed. And where do you get 6% interest with no risk nowadays? –  Lagerbaer Jan 22 '13 at 23:06

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