Originally, we sought to settle the question of when and how to pay off student loan debt definitively, with empirical evidence, once and for all. However, as we researched the subject and ran our own numbers, we kept running into the same conclusion: “it depends.” That is, the answer to this question is going to be different from person to person. With this in mind, we have instead discovered that a more helpful approach includes defining the pros and cons of saving money versus paying extra on loans each month – the advantages of which you can read about in greater detail here.
The Cases for Saving Money vs. Paying Extra on Student Loans:
Use inflation against student loans.
- Theory: Dollars you save lose purchasing power when they sit in a savings account because of inflation. You then use “old” dollars that are worth less than current dollars to pay your loans.
- Pros: In theory, you could reduce your interest rate by the rate of inflation.
- Cons: Not as useful if your annual income does not track ( or increase) with inflation. Not as useful in our current low inflation environment. Ultimately, inflation rates are out of your control and if deflation exists, you’ll have bigger problems than student loans.
Use student loans to lower your taxes.
- Theory: You can deduct the student loan interest from your taxes, up to $2,500.
- Pros: You save on your tax bill. If you have debt, this deduction is better than nothing.
- Cons: Unless this deduction can actually lower your tax bracket you may not save as much as you think. You typically save, depending on your tax bracket, 15-25% of the deductible interest – not the actual deducted amount. Of course if you claim this deduction, it’s implied you have debt. Disclaimer: The details of this particular approach are best taken along with your greater financial picture, which we can help with, or in a conversation with your CPA.
Invest the extra funds.
- Theory: Save extra money and invest it in hopes of returns that equal or exceed your interest rate of the student loans.
- Pros: Access to investments is easier than ever, and annualized historical returns of the S&P 500 typically exceed any student loan interest rate. Your net worth could increase through investment rather than stay neutral through saving extra money. On this note, if your company offers a 401(k) and matches any percent of your contribution to your retirement, never pass up on free money. Typically, if your investment timeline is long term (30+ years) the earlier you start investing, the better off you are.
- Cons: Risk. You must accept risk when you invest your money, because you could potentially decrease your net worth by taking a loss through investment. There is no guaranteed investment vehicle (think bank CDs) that has a rate of return exceeding your interest rate. If your end game is to pay off your student loans faster by positive returns through investment, the lifetime of your student loans is not a long enough time horizon to absorb the risk inherent with investing for the short term.
Liquidity is king.
- Theory: Having extra cash saved makes you more agile when life unexpectedly changes.
- Pros: Having some extra cash on hand can allow you to build an emergency fund. You can also absorb unexpected expenses when you have cash available, and avoid missing out on opportunities (like buying a house or investing) because you have cash on hand.
- Cons: If cash isn’t needed, you lose purchase power through inflation and interest paid on loans.
So, as you can see by the numerous options, arguments and pros and cons, when it comes to how and when you choose to pay off your student loan debt, “it depends.” There is no one size fits all solution, which means that the best solution is to understand or develop your financial goals and choose a course of action that best supports them.
Need help figuring out what the best solution is for your student loans? Call or email one of our experts.
Photo courtesy of Tobias Leeger
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