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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{ 22 comments… read them below or add one }

Wojciech Kulicki February 12, 2010 at 9:49 am

I’m with you. Financially, it makes perfect sense NOT to pay them off. But what often makes sense on paper doesn’t get put into practice…that’s why people use the debt snowball instead of the “pay off highest rate first” approach.

Psychologically, getting student loans off your back frees your money to do other things–and in the long run, that can lead to better results. Plus, when was the last time we actually saved/invested money we said we would when we “saved” it elsewhere in the budget…it’s tough to keep that discipline.
.-= Wojciech Kulicki´s last blog ..Should You Pay Off Your Mortgage or Credit Card? =-.

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Daniel February 12, 2010 at 10:07 am

I don’t agree. I’m in a similar situation, $22,000 of student loans at an average 2.8% interest. With SmartyPig I get 2.01% on my savings. Not much, but for the .79% difference, I get to keep my money in cash and use it as a backup plan. Or when the time is right, invest it and beat the 2.8% interest.

In the future, I’m sure both interest rates will increase, but there is something to be said for having control of your money.

I live in D.C. so it wouldn’t work for me, but what about Lending Club to earn a reasonable rate of interest? I haven’t looked into the details, but I bet reasonably risked loans could get you a decent return.

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Deacon Bradley February 12, 2010 at 3:35 pm

Interesting analysis Lakita! I’ve never seen someone crunch the numbers so hard and still come out on the ‘pay it off’ side. I’m with you and Wojciech! As someone who’s been debt free for 2+ years now I can honestly say you’ll win in the long run by paying it off. I’m a math nerd and I wish I could make the math work too, but y’all are both right. There’s much more working in this equation than math. I agree with one point Daniel made too: “there is something to be said for having control of your money.” And that’s exactly what you’ll get in the long run.

Go Gazelle!
.-= Deacon Bradley´s last blog ..Top 4 Characteristics of People with an Emergency Fund =-.

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PF Journey February 12, 2010 at 7:04 pm

@Wojciech Kulicki: I agree! Behavior is a huge factor.

@Deacon: 1st ~ Mega congrats on being debt free! All the math in the world can’t calculate the uncertainties. Sure, statistics can tell you what will probably happen, but ultimately it is unknown. I can’t control the market, economy, or interest rates…..but I can control my decision to accelerate payments.

@Daniel: I’m mad that you got a better interest rate than me…I should have shopped around! (Just kidding) I do see where you are coming from and as I stated, when I started writing this article…that was my thought pattern as well.
In essence you’re attempting to time the market to beat 2.8%. It’s still an element of chance and risk…though the numbers are conservative.
I’m very interested in the concept of social lending and I’ll probably invest in LendingClub or something similar in the future…but for now it has to take a back seat to paying off my loans.

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Mrs. Money February 13, 2010 at 9:17 am

We paid ours off much quicker than we thought we would and it has totally been worth it! I hated making those payments each month. Good luck with your decision!
.-= Mrs. Money´s last blog ..How Does Redbox Make Money? =-.

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PF Journey February 13, 2010 at 9:26 am

Mrs. Money,

Thanks! That’s encouraging!

Lakita

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Ken February 14, 2010 at 7:30 am

I would go ahead and begin paying it down. One condition: You have at least 1 months expenses in your emergency fund. No need to accelerate paying off debt if you’re not prepared for the ‘unexpecteds.’ Good Luck.
.-= Ken´s last blog ..Weekend Roundup =-.

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Bob Bessette February 14, 2010 at 8:54 am

Excellent analysis. I’m glad I found your site. I’ve always been a money-conscious person and enjoy figuring out ways to save money. I agree that debt is debt and there is certainly a psychological benefit to paying off debt. I don’t have any student loans anymore but I have just started acquiring loans for my daughter’s education. I will start to pay those off next month. I look forward to exploring your site more and to see more of your posts.
Best,
Bob
.-= Bob Bessette´s last blog ..5 Important Car Buying Tips =-.

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PF Journey February 14, 2010 at 10:37 am

@Ken ~ Excellent point, and it’s one I should have mentioned in the article. I have taken a “modified” Dave Ramsey approach. Instead of saving a $1K emergency fund as he recommends, I saved 1 month expenses….it is something I am more comfortable with.

@Bob ~ Thanks for sharing! I wish I had started paying off my student loans while I was in college. Even though they can be deferred, the interest accumulates. The sooner you can be rid of them the better!

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Kick Debt off February 15, 2010 at 8:25 pm

Kita, this was a very good analysis…. I love this and will be sharing it soon a kickdebtoff. My wife and i decided that we will be very aggressive at paying off the student loans .. its a mountain load of debt but we make progress each month.
.-= Kick Debt off´s last blog ..The 10 10 80 principle =-.

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Kris @ Debt Tips February 21, 2010 at 6:01 pm

No matter how you slice it, “low cost” debt is an illusion. Unless you have enough to pay off the debt completely and are using money like an investor.

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Divine and Debt Free February 23, 2010 at 4:45 pm

Wow you really crunched them numbers! Thank God I don’t do math and I leave it up to the experts lol.

I personally have an interest rate of 8% on 11,400 in student loans they have been around since God knows when and I haven’t even graduated from college talk about stupid!

I think there is a sense of freedom that no math can account for when you pay off everything including student loans. Starting in my I am in extreme attack mode and that 11,400 will be gone in 5 months its my last debt and I will be oh so free when its all ova!

I think more than the math its about how much you are willing to sacrifice. Great post I like this site!

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PF Journey February 23, 2010 at 5:00 pm

@Divine,

Thanks so much for stopping by! Attack that debt!!!! Stay connected ~ I’d love to hear about your progress!

Lakita

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Ronnie February 23, 2010 at 8:45 pm

Girl, I have $187k in student loan debt which, mind you, is down from $205k in 2005 when I graduated from law school. My highest interest rate is 3.1% variable, and half of my loans are fixed at 1.75% for the life of the loan. And you know what? I could care less how low the interest rate is. I don’t want to be paying $1200/month for the rest of my life on these loans!! Do you know what I can do with an extra $1200/month :D. I’m ahead of schedule to the point where my private loan processor adjusted my loan payments DOWNWARD because the original payments had me paying off the loans in 17 years instead of 20. And I know that those low interest private loans are going to go back up sooner than later, but right now I can’t find a consolidation for less than what I’m paying, so I’m paying off as much as possible before rates start increasing. Lord willing, I’ll have these puppies paid off by my 40th birthday (10 years); that’s the plan I’m working with. Great article!

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PF Journey February 24, 2010 at 7:09 am

Ronnie,

Sounds like you have a solid plan! I agree that you probably won’t find a consolidation loan rate lower than 3.1%, hopefully when it adjusts it isn’t by much. Either way, you may could try to negotiate it back down or consolidate (if the numbers work in your favor). Either way you’ve clearly demonstrated where paying off works in your favor….$1,200/month is a significant amount and I’ll celebrate with you when it is freed up to do other things!

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Peter February 25, 2010 at 9:24 am

Sometimes the best decisions that we can make aren’t the most financially sound – but they’re still the best decisions for you. With my student loans the APR was ridiculously low – like 2% or something – but I ended up paying it off quicker anyway just because I don’t like having debt – period.

I can’t even tell you what a weight was lifted off my shoulders when i made that last $1500 payment. It was such a relief to be debt free except our house! For that alone I think it’s worth it!
.-= Peter´s last blog ..What Documentation Do I Need To Claim The First-Time Homebuyer Tax Credit =-.

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Annika March 23, 2010 at 3:59 pm

Great article, Lakita! I’m glad I came across this. I’ll definitely be reading through the rest of your articles later today. I just had my exit loan interview today — yeesh! Frightening stuff! I have around $30K in loans after graduation in June and despite analyzing it from a few different angles my goal is to pay that off as soon as possible. I would like to begin investing at the same time, but I can’t stand being in debt! First things first though, I need a job! Hah!

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Dolla Thug July 24, 2010 at 12:04 pm

Yes – debt is debt is debt. Whether it’s so-called “good” debt or not! I hate it…loathe it…despise it! I’m totally with you and I’m about to get FOCUSED in order to destroy my $24K student loan balance ASAP!
Btw, loved the Dave Ramsey reference! :)

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AJ December 1, 2010 at 5:23 pm

Great article, my wife and I are struggling with this very issue. We’re doing the debt snowball plan on baby step 2 and the only thing we have left are the student loans (we sold our house last summer and are now renting).

One student loan has a high rate of 9% and God willing it’ll be gone by February 2011. The other two are huge (over $100k combined) with an interest rate of 4.5%…. I don’t know if we should go that long without saving a 3-6 emergency cash fund, 401k investing, etc…. I was thinking of stacking cash for 6 month emergency fund and then go crazy on the remaining loans…..

What do ya think?

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student loans July 15, 2011 at 6:40 am

Student loans are helpful for continual of a student’s study. I am a student of Mechanical Engineering of KUET. I need a loan to continue my study. But I don’t know anything about it. From which bank the credit is obtained? Anybody help me please.

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Erin August 9, 2011 at 2:42 pm

I’m struggling with this. I went to private undergrad and then law school, so between my DH and I we have 4 student loans. I’m doing the debt snowball and will have paid off my HELOC, and 3 of my student loans by December this year. All that is left is the large remaining student loan (~$32K) and the mortgage. But my interest rate on the student loan is fixed at 0.67%! I’m not kidding. Less than my ING savings rate even factoring in inflation. And I really want to save sooner to buy a house that has enough room for our family of five, plus I get a tax deduction on that small amount of interest. I know I don’t want any debt, but this seems sort of ridiculous to pay off early…or does it?

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Carole Kinneman January 8, 2013 at 1:26 am

Some really interesting information, well written and generally user friendly .

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