While paying off your student loans early seems like a no-brainer, it might not always be the best financial decision. In some cases, it could make better sense to put your money to work elsewhere.
Here are some of the pros and cons to paying off your student loans early, and some tips on how to pay them off.
Paying off your student loan debt early can save you a good chunk of money. For example, if you have student loan debt of $10,000 at an interest rate of 7 percent, with a loan term of 10 years, paying off the balance in full would save you $3,932.94 in interests. You should think of paying off debt as an investment. By paying off the $10,000 loan in full today, you are getting an annual rate of return of 7 percent. Not bad.
Paying off your student loans in full will also free up your monthly cash flow. If you make just the minimum payments in the example above, you’d be required to pay $116.11 per month for 120 months. By paying off the balance in full, you’ll have $116.11 more in your pocket each month—money that can then be invested for retirement or used to pay off other debt.
You would also lower your debt-to-income ratio, which is the percentage of your monthly income that goes towards paying debt. This makes it more likely that a lender will approve you for a mortgage. Lenders typically want a debt-to-income ratio of less than 36 percent, according to Zillow.
Even if you can’t pay off your student loans in full, adding just a little extra money to your payments each month can still make sense. For example, if you can add another $100 per month to your payments, for a total of $216.11 per month, you would pay off the loan in just over four and a half years. You’ll wind up paying $1,689 in interest--$2,243.94 less than if you made just the minimum payment each month.
Another great reason for paying off your student loans early is for the peace of mind. Getting rid of the debt once and for all means one less burden you’ll have to carry, and you can focus on investing for retirement or saving for a house.
If you have other debt at a higher interest rate, such as credit card debt, then it makes more sense to pay that debt off first. For example, you have $10,000 in credit card debt at 14.9 percent interest, and have the same amount in student loan debt at 7 percent, you should pay your credit cards off first.
Student loan debt is referred to as installment debt, which means you have fixed payments for a specific period of time. The influence it has on your credit score is less than revolving debt, such as credit cards. For this reason, paying off your credit cards first will have more of a positive impact on your credit score. However, you should make sure you don’t miss any student loan payments, as this can negatively affect your credit score.
The interest you pay on your student loans is tax deductible, so if you pay off your student loans in full, you will miss out on this tax advantage. However, the amount you can deduct each year in interest is the lesser of $2,500 or the amount of interest you actually paid, according to the Internal Revenue Service. Therefore, holding onto your student loans just for this small tax break might not be the best idea.
Paying off your student loans in full is also not recommended if it means draining your savings account or emergency fund. You should still have cash set aside in case of an emergency.
If the interest rate you pay on your student loans is low, it might make more sense for you to invest the money instead, but remember that investing involves risk and that you also have to factor in commissions, fees and taxes you’ll pay on investment gains.
Best way to pay off your student loans early
If you’ve decided that paying off your student loans early is your best choice, what is the smartest strategy to do so?
First, you should understand exactly how much you owe and at what interest rate. You should categorize all of your debt from the highest to the lowest rate, and work towards paying off the higher rate debt first.
It’s also important to find out whether your student loans are private or federal. If you have private student loans, you should understand that these loans tend to come with variable interest rates, instead of a fixed rate. With the possibility that interest rates could rise in years to come, student loan payments would increase as well.
Therefore, it’s better to have a fixed-rate loan because you’ll always have the exact same payment each month. For this reason, it could be a smart move to pay off your private student loans before your federal loans, even if the interest rate is lower.
If you can’t afford to pay off the loans in full, you might want to consider consolidating the debt into one loan. This makes sense if the loan you get has a lower interest rate than your current rate. You’ll combine all of your student loan debt payments into one simple monthly payment, making it easier to keep track of your debt.
Even if you can’t pay off your student loan debt in full or consolidate the debt to a lower rate, you can still try to make more than the minimum payment each month to save on interests and shorten the length of your repayment period.
Steve Nicastro is a staff writer at NerdWallet, a website dedicated to helping consumers save money and make smarter financial decisions.
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