Should I Pay Off My Student Loans Faster?
Today, around 70% of students in the US take some form of student loans. So once you start earning money, should you aim to pay off your student loans faster (or in full) by increasing the amount owed each month? (We’ll discuss the concept of consolidating loans at another time, which is the opposite of paying loans off faster and involves extending the life of a loan in exchange for a lower interest rate similar to refinancing a home).
First, to answer the question above, review your bottom line and also ask the following questions:
What is (are) the interest rate(s) on my loan(s)?
Are there any ways I can immediately reduce the interest rate(s) through things like setting up auto-pay?
How many payments are left on my loan?
Do I still qualify for a tax deduction of my loan interest based on my income level?
Once you’ve dug in a bit, try to consider the following: you’ve borrowed money from someone (a lender) and now you’re paying that money back at a certain interest rate. If you can achieve a higher rate of return on the money you’re repaying, you should pay your lender less (but still the minimum) and invest the rest in the area where you can achieve a higher return. Let’s put this into practice.
You have $30,000 in student loan payments and your interest rate is 4%. It will take you about 10 years to pay back this loan if you pay around $300/month. Total interest will be around $6,500, so you’ll pay a total of $36,500 over the lifetime of the loan.
Let’s say you have another $200 per month that you’re considering applying to your loan to pay it off faster.
So you’re considering increasing your payments to $500 per month. Now, it will take you 6 years to pay off this loan instead of 10 and the total interest will be around $3,500. So you’ve saved $3,000 in interest by paying $200 more per month and have cut the life of your loan by 4 years.
And assume you invest the $500 per month after the loan terminates for another 4 years (to complete the 10 year period) at a 4% rate, you’d accumulate around $25,500. So the upside is the $25,500 plus the $3,000 in interest that you saved, which equals $28,500.
Let’s dig into where else that extra $200 per month could have gone in those 10 years if invested elsewhere. If you were able to return 10% per year, that $200/month invested for 10 years would yield around $38,200.
So it’s worth holding on to the extra $200 per month if you can achieve a yearly return of 10% (even a 6% yearly return, which you’ll likely get if you invest in an S&P 500 ETF, will result in $31,600, which is higher than $28,500).
But if you can’t get higher than 4% on your own, it’s worth considering paying your loan off sooner.