Should I Hurry to Pay off My Student Loans

by Mike on February 12, 2010

I am NOT a fan of debt, so why in the world wouldn’t I pay off my student loan with “gazelle like” intensity?

The screenshot below will explain why I considered a less than aggressive payment strategy for my student loans. Think back to 2002-2003, college consolidation loans hit an all time low interest rate. Everyone was talking about consolidating! I couldn’t surf the Internet or watch TV without hearing about consolidation before the new rates applied. I consolidated and got locked into a 3.75% fixed interest rate. I don’t remember what it was before, but if I had to guess it would be around 6-8%.

Typically, I would recommend paying off debt before investing. For example, someone with credit card debt at 8% APR may be tempted to invest and hope for a 10-12% return. The problem is, you have a guaranteed debt vs. a probable return….it is apples and oranges. But what if you could guarantee the interest earned could be greater than the interest paid?

My original plan was not to include my student loan in my debt snowball because I was sure I could find an investment vehicle that would guarantee higher than 3.75. I got an ING Direct account in the good ol’ days when the APY ranged from 4-5% and 5% CDs were available at every bank. Well, in preparing this article I search for CDs, Money Market Accounts, and High Yield Savings Accounts that offered a 4-5% rate of return…and here is what I found out…they don’t exist! At least not in 2010. It’s a different world than it was 7 years ago. Here are the highest rates from bankrate.com at the time of this article:

  • 5 yr CD: 3.49%
  • 5 yr Jumbo CD: 3.20% (If I had $100,000 for a jumbo CD, my student loan would be paid off!)
  • Savings Account: 1.50%
  • Money Market Account ($10,000 balance to open): 1.50%

I even looked at government bonds (which are not guaranteed, but very low risk) and the rate of return is not above my loan interest rate of 3.75%

When I first started writing this article it was titled: Why I’m NOT in a Hurry to Pay Off My College Loans but when I took a close look at the numbers my game plan started to change.

 

My theory was that I could find some sort of savings account with a rate of return higher than my loan interest rate. I would save the money and at the end of the year I would apply a percentage of the interest towards my student loan and reinvest the rest. This plan was erroneous for the following reasons:

1. I was comparing fixed rate interest vs. variable rate interest: My loan interest rate is 3.75%. Period. However, the interest rates of CDs and Savings accounts vary over time. So even if I was able to find a 5 year CD at 5% interest (virtually impossible), there is no guarantee that I would be able to find the same interest rate again after the initial CD matures.

2. When an inflation is calculated, the difference in savings practically diminish. The graph below is from US Inflation Calculator however, I have plotted the average inflation rate over time (2000-2009) to be 2.87%. So a CD with an APY of 5% is only generating 2.13% return when inflation is factored in. Considering the average rate of inflation, I would need a return of 6.62% just to break even. I think it is safe to say nothing guarantees that high yield.

The bottom line – it is still DEBT! The Bible says the borrower is slave to the lender, and we are admonished to pay back what we borrow. Do I really want to be bothered with this monthly payment for the next 10-15 years? I don’t think so!

Also, there is risk involved in prolonging repayment. God forbid, but in the case of financial hardships that debt still has to be paid when it could have been paid off years ago. The unique thing about student loans is it’s pretty easy to get financial hardship deferments (almost too easy), however…while your loan is deferred that interest is still accumulating adding to your mountain of debt. Furthermore, student loans are not dissolved in bankruptcy (no, I am not advocating bankruptcy but I do realize for some it is a reality).

So, will I be adding my student loans to my debt snowball? I’m leaning towards yes! However, I also want to increase my retirement savings as I am nowhere near maxing that out. Gazelle like intensity on the student loan debt? Maybe a jack rabbit!

Are you paying off your student loans as quickly as possible or investing at the same time?

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