I have a student loan (9% interest rate) which I have to pay within the next two year. Since I have a secure job I know I will finish paying within two years even with the minimum monthly payment. However, to lower the total amount I will pay at the end of the 2 year, I was planning to pay extra every month (a couple of hundred dollars) and finish it early. However, I also come up with the idea of investing the extra cash I planned to pay every month instead of putting it to pay the loan.

Assuming that the investment will have a positive outcome, is it better to invest the extra cash, keep it in bank, or add it to the loan to finish it early?

UPDATE:**Thank you everyone for your response. I am obligated to pay the loan within two years. If I pay the monthly minimum amount the interest rate at the end of the 2nd year will be between $2500-$3000. However, I know that if I pay more than the minimum amount, the interest rate will be lower. But, how do I calculate how I would be saving lets say if I pay $200 extra each month or $3000 once? Or how much should I pay extra each month if I want to save $1000 from the interest?

  • Is it a government or private student loan? (It makes a difference in how I would answer) – JohnFx Apr 21 '12 at 0:10
  • Well. It is not a government loan. Its from private bank. – WowBow Apr 27 '12 at 1:17
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    Comment on update: $2500-$3000 is not an interest rate and the interest rate at the end of the 2nd year when the loan is paid off is irrelevant anyway. On most loans, the interest rate does not change depending on what payment you make. What does change if you begin paying more each month is how each monthly payment gets divided between payment of interest and repayment of principal. If you owe $10000 at 9% and pay $1000 one month after your last payment, the $1000 will be divided into $75 = 100000x(9/12)% interest and $925 principal repayment and next month, interest will be – Dilip Sarwate Apr 27 '12 at 1:59
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    charged on $9075 that you still owe. If instead you pay $1500, it will be $75 in interest and $1425 in principal repayment. So depending on which choice you make, you will owe either $9025 or $8575. So, the following month, you will owe either $67.69 in interest or $64.31 in interest. If you pay $1000 again, the amount you still owe will be $8142.69 = 9075 - (1000-67.69). If you pay $1500 two times in a row, you will have $7139.31 = 8575 -(1500-64.31) as the amount you still owe. – Dilip Sarwate Apr 27 '12 at 2:11

You have to have 9% ROI for your investment to break even. That's pretty steep. I'd pay the loan, where you have 9% promised return.

Just make sure that there are no pre-payment penalties, and that you're comfortable enough with not having that money available.

  • Actually, I could even pay and finish it within a year if I pay extra, which I am able to do ... However, I want to save for security purpose. Is that a bad idea? – WowBow Apr 20 '12 at 19:52
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    @WowBow you should have a cash cushion to support you for several months in case of an emergency, but that would not be invested, anyway. If you're asking which would be likely to save you more money, I'd say paying off the loan. – littleadv Apr 20 '12 at 20:11
  • Another factor to consider is that Government student loans typically can't be dismissed in a bankruptcy so the risk of carrying them is higher. That should factor into your decision too. – JohnFx Apr 21 '12 at 0:11
  • I put some updates to get more explanation. Please, take a look at it. Thank you. – WowBow Apr 27 '12 at 1:29
  • @WowBow I think you should put it as a separate question – littleadv Apr 27 '12 at 1:40

Your rate of return for paying off this loan is 9%, and that's guaranteed. For reference, the best rate of return on a 10-year FDIC-insured certificate of deposit today is 3%.

There's definitely something out there with better returns than paying off your loans, but there's definitely not going to be anything with better risk-adjusted returns than paying off your loans. Investors dream of guaranteed 9% rates of return.

If you had something that could provide a guaranteed 9% rate of return, wannabe investors would be lining up at your door and tripping over each other to outbid each other until it actually closer to a 3% rate of return. :P

(Postscript. Depending on whether your loans are tax-deductible and what your inflation expectations are, you could adjust those rates to make the comparison more accurate. But at 3% vs 9% the picture's pretty clear.)

  • I put some updates to get more explanation. Please, take a look at it. Thank you. – WowBow Apr 27 '12 at 1:29

What everyone else is missing is that it's 9% paid with after tax money. Any income you earn on an investment will also be taxed, so you'd need to make a fair bit more than 9% in order to break even with paying off your loan.

For example, if your tax bracket is 20%, you have to earn $1.36 for every $1 in loan payment.

Take $100 x 0.09 x 1.36 = $12.24 in pre-tax earnings just for interest every year on $100. Multiply that out for whatever the size

Pay off your loans first - it's a no-brainer.

  • I put some updates to get more explanation. Please, take a look at it. Thank you. – WowBow Apr 27 '12 at 1:29

The others nailed it, great answers. I'd add - the two things I'd prioritize ahead of this debt, higher interest debt, obviously. And matched 401(k) deposits. I can't repeat enough - many people are so anti debt, they walk away from guaranteed 100% returns. "after I pay my mortgage, I'll max out my 401(k) and catch up." I've read this, and it will never make sense. After that, pay off the 9% rate as soon as you can.

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