Should you pay off student loans early?

by on Sep 18 2012 - 57 Comments

Student loan debt is a reality for most of today’s college graduates. In 2011, the average debt at graduation for bachelor degree recipients was approximately $27,000. Some graduate with more, some with less, but almost everyone graduates with some student loan debt.

Student loan debt is so-called “good debt” because it is an investment in your future earning potential. Completing a undergraduate or a graduate degree program can pay dividends in the future from all the doors it can open. Student loan debt is different than other debt because even if you declare bankruptcy you will still have to pay it back.

The question I want to ask today is: Should you pay off student loan debt early?

Personally I would advocate against paying back your student loans early for these two reasons:

  • The interest rates on student loans are usually fairly low. Because interest rates are largely dictated by the Federal Reserve vs. the free market, interest rates are currently artificially low. True inflation is likely much higher than the stated amount (think 6-8% vs. the official percentages that are quoted by the government) because it takes a while for inflation to spread throughout the economy. Assuming your student loans have an interest rate that is less than 8%, you really aren’t losing much by only paying the minimum.
  • Build an emergency fund and build investments instead. Instead of paying off your loans early, use the additional money to build up an emergency fund or start stashing away money in your retirement accounts. As I already stated, the interest rates usually are pretty favorable on student loans so you aren’t losing as much as you think on the interest. Use your additional cash to build a safety buffer in the form of an emergency fund or get some exposure to the market in the form of investments.

There is one situation where you may want to pay down student loans early. If you are trying to get pre-approval for a home loan, the loan officer will look at your debt-to-income ratio. There is a limit (somewhere around 43%) to how high this ratio can be before you are automatically disqualified. Oftentimes student loans make up a big portion of an applicant’s debt. If your ratio is too high, then paying down student debt early can help you bring your ratio down low enough so that you can get pre-approved for a mortgage.

In the majority of cases it is best to not pay off student loan debt early and focus on other financial priorities: emergency fund and building investments.

Do you think people should pay off student loans as quickly as possible or should they only make the minimum payments?
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48 comments
Chris_E_Johnson
Chris_E_Johnson

Being a current undergraduate student, I found this topic very interesting and couldn't help but read all the comments to get other's opinions. I think both sides have good intentions but in the end it all comes down to what you can afford. Making sure you are able to make your minimum monthly payments on student loan debt is number one. But I also think that getting rid of that debt is equally important as I don't want to be paying off my loans for 10+ years (on a side note, student loan debt is considered "good debt" by lenders and isn't usually an issue to your credit score if timely payments are made). On the other hand, I find it very valuable to begin contributing to a Roth IRA immediately after school to take advantage of my time horizon opportunities. Thanks for the post and all the comments from both sides!

smniskan
smniskan

This is a tough one for me! I just graduated from college two weeks ago with about $64,000 in student loans and I don't have a job. Once I have a steady source of income (and God-willing, this will happen soon!) I can't imagine not putting my extra money towards my loans. I just don't think I'd feel comfortable having a nice wedding, or buying a new car, or even having kids until the debt I accumulated during college is payed off. It's a huge burden that if I had the money to pay off, I would in a heartbeat!

thetightwadtale
thetightwadtale

DC, I'll agree with you. I threw practically all my money into my student loans a week before my job ended...without an emergency fund...suffered for a good three months. It's not just about investing and saving up for an emergency fund for me though. It's about living comfortably, and having a better standard of living with the extra cash. That is, I could easily afford the minimum ($80/month) for the next six years of my life and live a slightly more care free life, or throw most of my income into it and hope I don't get an expensive dental bill...'cause then I'd just be screwed..

One Cent at a Time
One Cent at a Time

Any debt is to be paid off on priority unless there's some more compelling reasons like saving a life, etc. Sure you need to build emergency fund, but once you reach certain limit you got to stop that to pay off debt. My opinion..

moneyaftergrad
moneyaftergrad

What investments are getting you a return >8%?

 

Emergency fund, fine, but I don't think you should pay the minimum on your loans and use the rest of your money to build investments. Maybe split it and put 2/3's of your cash towards the loans and the rest towards investments..

Money Life and More
Money Life and More

My girlfriend's worst loan is a variable 8.25%. We're paying that off as fast as possible. She also has variable 4.75 and 5.75% loans and when the interest rates start going up we could be in trouble.

 

She does have fixed rate loans but they are at 6.8% which is pretty high. We'll just pay all of her loans off as fast as possible.

seedebtrun
seedebtrun

I had my answer in mind before reading, and it will stay the same after reading your post.  :)  YES!  I have credit card debt of ~10k, but it's at 0%!  0.  Goose egg.  It will remain 0% until past our debt-free goal date.  I know that a lot of people think of student loan debt as being not as dangerous or as awful or as evil as consumer debt, but DEBT IS DEBT imo.  As soon as we're through tackling this cc debt, we're onto the car loan, which should be paid off fairly soon after, then onto the house with the same tenacity.  We want to be debt-free, not just consumer debt-free.

-M

OneSmartDollar
OneSmartDollar

I think it all depends on your interest rate.  If it is low then there isn't much point in speeding up the payoff process.

KelseyJass
KelseyJass

We are paying significantly more than what we would be with a mortgage in student loans per month, and if we don't pay more than the minimum . Even with low interest rates, over 40% goes to interest if we pay only the minimums. Though that will change with time, we are working to get all our student loans paid off ASAP (or at least change that principal to interest ratio).

moneymatters
moneymatters

I think there are a lot of factors that go into whether or not to keep those student loans, and whether to pay them off or not.

 

I think things to take into account include the interest rate as you mention,  other debts you may have, and just how debt averse you are.

 

For us I was the only one with student loans when we got married, and I only had about 10k of loans left to pay.  For us our only other debt was our mortgage, and even though the loan was only 2-3% interest, I hated having that debt just hanging there. So we paid it off within a few month to free up that monthly cash flow, and be able to really start saving/investing.  Of course we had an emergency fund built up, and no real other obligations, which made it easier.

Veronica @ Pelican on Money
Veronica @ Pelican on Money

I treat my student loan like another bill - set it on auto-pay and forget it. The amount of interest I'm paying is not significant enough for me to throw extra money at payments (I like to use those funds and building new web properties instead that end up generating continuous revenues to pay the interest anyway).

OutlierModel
OutlierModel

I think that unless you had other debts, especially consumer debts, there's no reason not to pay off the student loans and free up monthly cash flow.  Brian paid off his student loans very quickly from income gained from an extra job and it's definitely great to not have the burden of an extra monthly bill.

Eyesonthedollar
Eyesonthedollar

I think it would have been smart to pay more toward student loans when I first graduated, but then I might not have been able to buy my business or a house, which were more of a priority. I am all for paying down debt, but not at the expense of missing retirement contributions. If you are smart and make decent money, you should do both. I wasn't and got into credit card debt, dumb, dumb, dumb. The remaining student loans  have are at a low rate and they will get paid off eventually.  

FrugalRules
FrugalRules

I would tend to agree with Holly, that it is personal preference.  You make great points about the interest rates and building up things like investments and an E-fund.  I would probably prefer to pay them off early, assuming I had other things covered, as I am no fan of debt and don't relish the thought of making payments for years on the loans

SenseofCents
SenseofCents

I want to pay my quickly. I want my student loans gone, and I expect to pay off around 30,000 by early next year.

bogofdebt
bogofdebt

I agree with Holly. I think it's a matter of personal prefernece.  Right now, I'm paying minimums (rounded up to nearest $5) but eventually I will be paying more on them.  I want to be able to start a family without having them hanging over my head.  I also had a late start so that could be why I really want them gone.

Holly at ClubThrifty
Holly at ClubThrifty

We prepaid Greg's studen loans - around $17,000 but it was mostly because we are so debt averse.  It was at a fairly low interest rate - 4%.  I don't regret it though.  We are debt free besides our home and it feels great!

 

I think it's just a matter of personal preference.  Of course, I wouldn't have paid off his student loans had we not had all of our other ducks in a row first!

DC @ Young Adult Money
DC @ Young Adult Money moderator

@smniskan I definitely understand where you are coming from.  In the same boat, actually, but one "nice" thing about student loans is that you will make more money over the course of your life since you have a college degree as well as the fact that it seriously motivates you to make more money and to get your finances in order.  Best of luck on the job search (perhaps you have one by now?)

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @thetightwadtale Finally someone who agrees! Haha jk I think others generally get what I'm saying but are so fanatical about getting rid of debt regardless of other variables that they just can't stomach not paying it off asap.

 

There's no rush to pay off student debt if the additional money can be put to better use.  Emergency funds ARE a better use.  Investments into retirement ARE a better use.  I agree with you, it's best to have access to that cash than to pay down a loan faster.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @One Cent at a Time Even if someone loaned you $50k at .25% interest rate?  I think saying "no matter what debt should be payed off asap" is bad advice because it doesn't factor in the inflation variables, how much you can make off of investing vs. how much it costs to borrow, etc.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @moneyaftergrad Never said I was getting a return >8%, I'm just saying if you have loans around 5% interest rate there really should be no rush to pay them off because you are already beating inflation.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @seedebtrun Does having kids factor into any of this?  I know many people who want to be debt free asap regardless of interest rates, and oftentimes children are a part of their answer.  

 

I also think a lot of people have their mind made up about this...very interesting to read the comments that came out of it.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @KelseyJass I feel your pain, as we are paying a little over 1k a month and it's a real drag on finances.  The principle/interest ratio sucks at the beginning of loans.  After paying a mortgage for five years on a 150k-200k loan you really haven't built much equity.  You have built some, but just a lot less than most people would imagine (If I'm not mistaken, it's between 5-10k in equity build up after five years!).

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @moneymatters I know you are a fan of Dave Ramsey (at least I think you are?) and I believe he advises paying down debts as fast as possible (even mortgages), so I can understand why you would want to get rid of that debt.  I just can't get over the interest rate argument and I think I would be just as comfortable having 100k cash/investments and 80k debt as I would with 20k cash/investments and 0k debt.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @FrugalRules I'm not a fan of debt either and I don't like the thought of making payments for the next 10+ years, but if I know that inflation is higher than the rate I'm paying (I know that you can't KNOW for certain...which is part of the reason inflation is such an evil tax....) I will gladly keep the debt on my books while putting funds towards other investments.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @SenseofCents But the rates.....haha okay I won't even try to convince you otherwise, definitely can't blame someone for wanting them gone.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @bogofdebt Ah I hear you there I have a friend who wants kids asap, but won't have them until they both have their student debts paid off.  That's a legit reason.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @Holly at ClubThrifty I agree it really does come down to personal preference.  I'm more comfortable having the loans while building up my other balances, mainly because I'm super focused on the rates ;)  They trump everything for me.

alxvallejo
alxvallejo

 @DC @ Young Adult Money  @One Cent at a Time There's a lot of leeway between .25% and 8% as you mentioned in the OP. Even if inflation were 4%, you'd have to offset that with a 4+% investment somewhere else and uncertainty in the markets can make those retirement savings risky. I've been out of the game however and I don't even know how easy/risky it is to make 4% per year on any investment.

KelseyJass
KelseyJass

 @DC @ Young Adult Money I am glad we are not the only ones with those payments:) That does sound right. We may not keep being aggressive as we have been thus far - but right now, it seems to be our best option. We are still putting a decent amount into savings and retirement accounts - so we aren't totally screwing ourselves over:) I think at this point it is more of a psychological win than anything to know we are making progress.

moneymatters
moneymatters

 @DC @ Young Adult Money I like Dave Ramsey on some things, and not as much on others (like investing).  With that said, I do believe in paying down debt as fast as possible, freeing up monthly income in order to save and invest, especially when the student loan debts are at a lower more manageable level that can be paid off quickly.  By the way, we were still saving and investing to a degree while we paid off the student loan, it wasn't either or. 

 

Now of course if your student loan debts are larger, it may take a while longer, and I would say that in those cases I'd be more inclined to go along with the interest rate argument, and keep those loans for longer and play the interest rate game.

 

But for me personally, I just prefer to have a situation where I have more cash flow every month, and I don't have to worry about any monthly payments except our mortgage. The sense of freedom i get from that is amazing.  Plus, now that all student loans are paid off we can really get crazy about saving/investing with all the extra cash flow freed up from that payment.

 

 

Veronica @ Pelican on Money
Veronica @ Pelican on Money

 @DC @ Young Adult Money I had the chance to pay down my loans 3k one day but instead put that money into purchasing a website I've had my eye on for a while. Investment paid off - website generated 40k and my student loans remain. I could have paid them off right there and then with the profits but instead I put that money into another project lol.

SenseofCents
SenseofCents

 @DC @ Young Adult Money Haha well I think of it as, I can pay off my student loans in 15 to 30 years like my loan repayment plan says, or I can start paying it off in 4 months, and wipe out $30,000 in just 4-5 months.

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @moneyaftergrad I don't think you heard me, I think those rates are inaccurate.  I don't have the space in a blog comment to explain my views on economics and why 3% inflation isn't even close, but if you are interested (most people aren't) check out "Crash Proof 2.0" by Peter Schiff, "Aftershock" by David Wiedemer, and "End the Fed" by Ron Paul. 

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @moneyaftergrad I strongly disagree that inflation is 3%.  I believe the true rate of inflation is in the 6-8% range (that's conservative too, I think it could be 10%).  I stated this in the post above.  The thing is, inflation is only going to get higher based on how the Fed is handling the economic crisis.  They are doing everything in their power to devalue the dollar. The fact that QE3 is happening is even further evidence that inflation is much higher (and will be much higher in the future) than 3%. 

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @KelseyJass Yeah I definitely can't fault you for wanting to knock down the balance a bit.  I have accepted the reality we will be paying at least $1k a month for about 10 years and feel good about not paying off more than the minimum, so I guess whatever makes you feel better.  I know that if I felt better about paying off more than the minimum we definitely would as well!

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @moneymatters Ah okay that definitely makes sense.  We do face a loss of $1k of cash flow each month because of our loans, and I understand how you could free up your cash flow by getting rid of them....but it almost becomes a question that would have been asked in a finance class of opportunity cost of paying it down or opportunity cost of investing that money you would have used to pay it down, with rates factored in....anyway I agree this could go on and on but in the end people are going to pick whichever argument makes more sense to them, and I'd say as long as you are NOT paying down your debt for the right reasons (i.e. not blowing the cash on things but using it for investment purposes) then it is okay to pay the minimum (as long as the rates agree!)

moneymatters
moneymatters

 @DC @ Young Adult Money It's not just the psychological aspect of having that sense of freedom, it's also about having more cash flow available, which can be especially good if hard times hit and you need all the extra money you can get. And if hard times hit and the worst happens, often those student loans aren't bankruptable either, so in that case you'd be stuck still having to pay them. 

 

In any event, I think there are pros and cons to each side of the debate.  Great post for getting the discussion going!

DC @ Young Adult Money
DC @ Young Adult Money moderator

 @moneymatters I understand your argument, but still am sticking to my interest rate argument regardless of how much you have taken out ;)  I do understand that there is a psychological aspect to it where having $0 go out the door to student loans each month gives you a sense of freedom.

SenseofCents
SenseofCents

 @DC @ Young Adult Money I do agree with you though, don't get me wrong! The reasons above are why we took out a car loan instead of just paying for it all in cash. Most of my student loans are variable rates (yes I was a stupid 18 year old), and variable rates scare me, so I that's the main reason why I want them gone now instead of later.