Why You Should Pay Off Your Student Loan Early
The cost of education is sky-rocketing, and no one can deny that. Tuition has consistently increased at rates well above that of inflation each year. Just 50 years ago when someone went to college, it might cost them about $300.00. Now it’s costing people $40,000 to go to college, and that’s at subsidized in-state tuition rates. For more expensive programs, it’s costing upwards of $100,000! For some of these programs, there is not enough financial aid in the world to pay for. Inevitably, most college students end up with some sort of student loan. Most of the time students get federal Stafford loans to help pay for their school, and often times get private loans on top of that to pay the remaining cost.Recently there was an article telling you that you shouldn’t ever pay off your student loans early. They had a couple of rather thought provoking reasons for this. Their primary motivation was that in the event that you become permanently disabled or die before your student loans, you or your estate will not have to pay off your loans before you die. The article claimed that it was essentially a free disability and life insurance policy.
Is this a good reason to not pay off your student loans? The answer is no. The fact is that you are paying a lot of money for the privilege of this disability and life insurance policy. Let’s say you have $25,000 in student loans at the current federal rate of 6.8% This means that you are paying $1700 a year or $141.67 a month for a $25,000 life insurance policy. Not even term insurance is that bad! If term policies were offered for that little amount of money, you could get it for just a few dollars a month. In essence, you are paying 70 times the going rate for this term and life insurance policy!
If instead you pay off your student loans you are getting a guaranteed 7% rate of return on your money, and that’s a very good investment. Most other guaranteed investments are currently offering 4% or 5%, you are getting an addition 2% to 3% compared to any other guaranteed investments. It gets even better than that. You are not getting 7% back, you are getting 7% back per year for the life of your loan! This can often be ten or twenty years! The 7% turned into 386% after 20 years! When you pay money down on a loan, it is like you are saving the interest for the entire term of the loan!
Don’t fall for the myth that you should not pay on your student loan so that you can get some sort of interest rate on your money!
When it comes to paying for college sometimes Student Loans are unavoidable. There are a multitude of options available from Sallie Mae Loans to Pell Grants you can find out your eligibility for Student Loans by filling out your FAFSA Online.
posted by Matthew Paulson @ 11:20 AM
14 Comments:
I'd like to preface with that I enjoy your blog and appreciate your articles and am only contributing my $0.02.
First, if anyone is paying 6.8% on their student loans, try a Google search for 'refinance student loan'. You should be able to get around or under 2%.
Once you've done that, contributing more than the monthly minimum payment is foolish. Any payment made over and above the monthly minimum would be better spent in a 4-5% online savings account or, better yet, an index fund.
Even considering the scenario where you have $25k gathering dust, you're better off investing it than paying off a 2% student loan.
There are several sites/blogs/articles/financial advisors that back this up. I'm not sure where your math went wrong. Or perhaps I missed the point of the post.
Oh yeah...interest payed on student loans is tax-deductible.
Yeah, you do get a tax deduction, but you shouldn't pay the bank/student loan folks 6.8% so you can save from paying taxes on 6.8%. If you have $25,000 in student loans at 6.8%, you're sending the bank $1700 a year so that you can not send the government $425. (assuming a 25% rate)
Yes, you're right. You should refinance and pay them 2%. :)
Hehe, I don't have any student loans...paid them off! :)
Mike,
I seriously doubt you have done real searching on refinancing student loans. Federal rates are currently fixed at 6.8% and the only thing that refinancing will get you are lender incentives for 24-36 on-time payments (to the tune of a rate reduction of .5-1.5%) and possibly for automatic payments (reduction of .25%). You are still talking around 5% at best, and that is only after at least 2 years of repayment. If you have private loans you are even worse off and would be extremely lucky to find 7% even with perfect credit. At this point, 2% refinancing is pie in the sky. 3 or 4 years ago the federal loans were a different story, and I am glad to say I locked in 2.85% on mine (which I am in no rush to pay off), but that time is long gone. It looks like Democrats have gotten the rates for new loans down to 3.4% next year, but that doesn't help those with current loans.
I don't know what the current rate on student loans is, but mine are fixed at 4.25%, which is less than what I earn on my Emigrant Direct account. I consolidated the Stafford loans five years ago when rates were on their way down, but had not yet reached rock bottom.
I actually consolidated at 5.25%, but I got a .5% reduction after 48 months of on-time payments and another .5% for letting the lender draft my checking account each month.
I do have one private loan that I could not consolidate. It's got a variable rate that currently is 8.07%. Fortunately, it's a fairly small loan.
Also, the tax deduction for interest phases out as your income increases. So, you can't count on it.
Mike, hate to burst your bubble, but I can tell you with great confidence that there is ABSOLUTELY no student loan, government or private, that has a 2% rate. I appreciate your view that paying off loans early is a bad idea, but your suggestion that refinancing is available at 2% is completely wrong.
There are actually 2 VERY important facts that MUST be included in your information.
1) If you refinance your student loans and it increases the total amount for repayment by ONE RED CENT, you can no longer claim the interest as a tax deduction. Even if you refinance at a lower interest rate, with combining the loans, it will be increased. So, combine your loans in a refinancing situation and lose your tax deduction.
2) Regarding your loans being erased in the event of your demise: ONLY if no one else's name is on the loan. That means that if you took the loan out with your parents, they will then be responsible. If you refinanced your loans and put your spouse's name on the new loan as well, your spouse will be responsible. NEVER, EVER add anyone else to your student loan if it can be avoided.
Thanks for the advice in the above post, some very good insight!
Terribly sorry to give the false hope of a 2% rate. I was recalling the rate available when I graduated 3-4 years ago.
Nevertheless, let's use the 6.8% rate and a handful of reductions mentioned before; a ~5.5% rate (or perhaps 3-4% in a year to come). You are far better off not making additional payments to your student loan. Use the extra money to start a Roth IRA account and invest in a Total Stock Market Fund. Risk, yes. Risky, no.
The fundamentals remain that over the life of a 15 year student loan, as the market is predicted to average 9%, paying off your loans early is poor advice.
Unless, of course, you are locked in at 8%+ and have absolutely no way of getting out of it.
Fed rates change; fundamentals do not. Be wary pop-culture finance.
When my grades slipped, my full scholarship at Caltech (where I'd arrived age 16 in 1968) slipped to a partial scholarship and student loans -- at 3% interest. By the time I'd gotten my double B.S. in Math and English Literature, and gone to grad school (more loans), gotten an M.S., and more loans, it was the Carter administration, and inflation was running somewhere in the neighborhood of 20%. So I felt little incentive to pay off that 3% loan quickly and, in fact, didn't finish paying it off until 17 years after it started. Should I give back my Math degree?
Another grad student in that department took out the maximum possible student loans each year, bought a defunct ski lodge in Vermont, insured it, and it mysteriouslky burned down. He made quite a profit on his student loans. Should have been going for an MBA, maybe?
-- Jonathan Vos Post
http://magicdragon.com
read the article, meathead. you are flat wrong. you deserve to pay 6.8 interest...
Well, I work in the student loan consolidation business. I can guarantee that nobody would be able to lock in a 2% rate today. Three years ago you could get close to this (after incentives). 3.4% could be brought down with .6% off for consolidating in grace, .5% off for ACH and 1% off for 24-36 on-time payments depending on your lender, but OF COURSE these are INCENTIVES and you'd only realize the benefits by paying less in interest overall and paying your loans off early.
Also there's a misconception that people have: 6.8% is the rate for NEW LOANS this year (loans being disbursed). And it's a fixed rate. Every body else has a variable rate and most are different.
Usually rates I encounter on a daily basis average around 5% (some got higher rates in the 90s and others got lower rates a few years ago).
I agree with Mike--if somebody has the CASH to pay off their student loans, they'd be MUCH better off making a low-risk investment. With something creative like tax liens, people can easily make over 10% with virtually no risk. Not bad!
Also, look at how consolidating could help in a unique way: the average person with about $40,000 in student loans at around 5% will pay about $430 a month. After consolidating, they will pay about $230 a month. Yes, the loan term is extended, but there are no prepayment penalties. Anyhow, that extra $200 a month can not only pay for extra bills, clothes, cars, etc (what most people do with their savings) but it can ALSO be used to fund a retirement plan. That extra $200 could go to fund an employer contribution-matched 401(k) and make 8% and by the time you retired 30 years later you would have over $550,000 for retirement. not bad eh?
With a 1.25% incentive off your rate, in that time you wouldh have paid about $19,000 in interest VS the $10,000 you would have paid without consolidating.
So paying off your loan faster may have saved you some interest, but the MAGICAL QUESTION IS: could the money you’re using to pay off your debt be more helpful to you in some other way? When facing paying off credit cards, the answer is often “no”… but when looking at paying off student loans, the best bet is USUALLY to use that money elsewhere.
What do you think?
I work at University Loan Services and help people
consolidate their student loans. My name is Jason. You can visit universityloanservices.com
Feel free to call and ask me any questions.
Of course, I hate debt just as much as the next guy, so I even have to force myself to do the “logical” thing sometimes.
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