Thanks to the CARES Act, Federal student loans have been on pause for the majority of the year, allowing borrowers to forego payments without accruing any penalties or interest during this time.
Those payments are expected to start coming due at the start of February next year. Once student loan payments start again, a common question is “should I prepay my student loans with extra savings? Or should I be paying the monthly amount and saving any excess elsewhere?”
This can apply to almost any debt that you have, and of course the answer is always specific to each individual. Your paydown is a function of savings capacity and other goals you are trying to accomplish. In terms of student debt specifically, I will lump these into three categories: financial decision, emotional decision, and other considerations.
The following assumes that you have to be in a position of having extra savings, and now you are determining what you want to do with the extra savings. Extra savings come after you have covered all your expenses (including monthly debt payments) and built an emergency fund.
There is rarely a “no-brainer” financial decision in instances like this because you are going to have to make a few assumptions (read: guesses) around market returns and other factors going into the future.
The first step I would recommend is find the “net cost” of your student debt. In other words, some individuals get a tax deduction for interest paid on their student loans, which lowers the actual cost of the interest. As an example, let’s say your interest rate is 8% on your student loans and you paid $1,000 in interest this year. We’ll also assume you are single and within the income limits to claim the deduction.
We’ll say you’re in the 22% federal tax bracket, and you are in a state with no income tax for simplicity sake. When you pay that $1,000 of interest, that counts as a deduction - in other words, you do not have to pay taxes on $1,000 of income. Therefore, you save 22% of that $1,000 or $220 making the interest a net cost of $780 or 6.24% (8% * (1-.22). Replace the 22% with whatever your marginal tax rate is among the Fed and State to get your net cost.
Now, it is time to consider arbitrage - this is where you can borrow from one pile of money at a lower cost, and use that money to get a higher return. So you have two options in this scenario:
Pay down your debt and get a “return” of 6.24% from the interest savings.
Don’t pay down your debt and use the money to get a net return better than the “cost” of that money which is 6.24% in this example.
Are you willing to take the extra risk in hopes of receiving a better return than the interest savings? This leads to the next decision; the emotional decision.
On one side of the emotional decision is what I mentioned above - do you feel comfortable taking on extra risk (e.g. market risk), when you could just get the “return” of paying down debt without the added risk?
Another emotional decision is that many people hate the feeling of having debt. They don’t like owing money or having a monthly payment that feels like it will never end, with a large negative number on their balance sheet.
In my example, I used a pretty high interest rate. But in some cases, I have seen student loan debt interest rates as low as 1.45%!! This makes the financial decision a bit more clear, but it still doesn’t take away the emotional decision. If it keeps you up at night knowing that you owe this money, then the decision may be to just pay it off and forget about it. The financial gain may not be worth the emotional cost.
Standard payment plan - this article assumes you are on a standard payment plan with a fixed interest rate, whether that be with the Federal government or a private loan company. There are also options to be on an Income Based Repayment plan with the Federal government, which have their own rules and strategies which I have not touched on. If you are following one of these plans, make sure you know your plan to pay off the debt and determine what makes sense. A clear example is if you are going for loan forgiveness, you want to maximize that forgiveness amount and do not want to be prepaying your loans.
Refinance - as alluded above, you can also refinance your loans as a way to lower your interest cost. You can still deduct your interest cost in a private loan the same as you can in a public loan. Just know that if you refinance to a private loan, you may lose the benefits that the Federal government provides (like paused payments during COVID and Income Based Repayment plans).
Excess Savings Capacity - I want to make clear that this blog is about maximizing your savings capacity to help you accomplish your goals. I am not condoning to forego prepaying your loans to go lease a sweet BMW - I am focusing on using that extra capacity to pay down debt or build up savings to fund future goals.
Company match - The arbitrage is clear in an employer retirement plan match scenario - if you have extra savings capacity, get your company match first, as this is a 100% “return” (which I would take over 6.24% any day!).
“All or nothing” - The decision does not have to be all or nothing. If you have an extra $1,000 you can put $500 towards loans and the rest to other goals.
It takes a lot of planning to stay on top of your finances with so many competing priorities. It is a tough balancing act when you have debt you want to pay off, future goals you want to save for, all while having the money to enjoy your life today.
No matter what, it takes a lot of time and effort to get into a financial position that you feel truly comfortable in. Having a plan and taking action steps to get into that financial position is a great starting point and may relieve some of those financial worries.