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There are lots of questions on SE about investing versus paying off student loans. This is not one of those questions. This question is about investing while you are still in school to pay off student loans later.

I am in graduate school for the next three years. I have student loans that are accumulating interest. But until I finish graduate school, the interest will not capitalize. The interest is therefore not accumulating interest.

My goal is to pay off all the student loan interest before I graduate so it does not capitalize.

I am debating between two strategies.

  1. Pay off the student loan interest gradually over the next three years, aiming to have none left when I graduate.
  2. Invest the money I would have used to pay off interest. Then in three years, use the investment to pay off all the interest.

I am leaning toward (2).

With (1) I get to use my interest payments as tax deductions each year, which is only valuable if it bumps me into a lower tax bracket. [Incorrect, as noted by @jmg229 below.]

With (2), there is risk that my investment will actually be smaller in a few years. But with relatively safe investment (like bonds?), even a low-yield investment will probably pay some interest above inflation. Since the student loan interest is not itself accumulating interest for the next three years, it seems like investing makes more sense than paying it off now.

It is relevant that the amount of interest is large enough that I could not feasibly pay it all off and start paying off principle soon.

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    Note that the shifting tax bracket business is never relevant: you always pay the same tax on the same amount of money, even if you make more - you pay more tax on that higher amount of money, but it doesn't shift your amount under that any. (IE, you pay 0 on the first $10k and then 10% on the next 10k and then 15% on the next 50k etc. or thereabouts, regardless of where you fall in that range). – Joe Feb 17 '15 at 19:03
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I would not advise this for two reasons:

  1. Your point that the investment could be lower at the end of the 3 years is a concern, although with a safe investment, it is less so, but this reduces the potential gain.

  2. While your interest is not gaining interest, your interest charged is based on the principal. If you pay off the loans, you reduce the principal and therefore you pay less interest in the long run, even if the interest isn't capitalized. All that this means is that you are basically being charged simple interest as opposed to compounding interest, but reducing the principal helps in either case.

You are mistaken about the benefits of the tax deduction. You reduce your tax bill by the marginal rate times the student loan interest you paid for the year. So if you are in the 15% tax bracket and paid $100 in interest, you save $15. This is not a reason to keep the loans (because you have to pay $100 to get $15), but you are mistaken on the benefit, it has nothing to do with shifting the tax brackets.

Also, speaking of taxes, don't forget that you pay taxes on investment gains.

  • Samsonite! I was way off! Thanks for the lesson in tax deduction. Just to be clear, you're advising option (1) from my question? – Dr. Beeblebrox Feb 13 '15 at 14:38
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    Yes, I would definitely advise option 1 – jmg229 Feb 14 '15 at 4:22
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    +1 the market's return is much more consistent over periods of 10 years or greater. Anything under 5 years is a dicey proposition. – JAGAnalyst Feb 17 '15 at 18:38

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