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What Should I do with a Low-Interest Student Loan?

A student loan with an excellent interest rate opens doors for retirement, buying a house, and investing.

Written By: Michael P. Lux, Esq.

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If you have high-interest private student loans, paying them off as quickly as possible is an easy decision. It might not be easy to eliminate the loan, but there is little doubt that eliminating it quickly is the best approach.

Loans in the 2-4% interest rate range are easier to manage, but they present unique challenges. With a low-interest student loan, there isn’t an obvious strategy.

Even though the decision isn’t necessarily easy, the good news is that borrowers have many excellent options.

The Big Perk of Low-Interest Student Loans: Saving for Retirement

There is plenty of debate over how much savers should expect their retirement accounts to earn. Most experts and financial planners project the long-term number to fall between 7-10%, but some project slightly higher or slightly lower interest rates.

What isn’t up for debate is that in the long run, retirement investments should earn more than the 2% or 3% charged by a low-interest student loan. This means that retirement contributions should grow faster than the interest generated by the student loan. Tipping the scales further in favor of saving for retirement is the tax breaks. Retirement contributions to 401(k)s and IRAs can dramatically lower your tax bill. Additionally, the student loan interest paid also qualifies for a tax break.

Borrowers who choose to focus on retirement can make minimum payments on their low-interest student loans to maximize retirement contributions.

Building Up an Emergency Fund

Some people view having an emergency fund as a luxury. I tend to see it as a necessity.

With some savings accounts currently paying 3% or more, setting money aside for a rainy day looks especially tempting.

However, the value of an emergency fund doesn’t come from the interest it earns. Instead, the value comes from being prepared for unexpected expenses. Surprise medical bills, car trouble, or housing costs add up very quickly. Those without emergency funds often resort to high-interest credit card debt or payday loans. Things can quickly spiral out of control.

Having an emergency fund helps prevent one problem from causing many more problems. Even borrowers with high-interest student debt should still set aside some money for a rainy day. Having low-interest student loans makes it easy to build up your emergency fund.

The Case for Aggressive Repayment of Low-Interest Student Loans

I can’t make an argument using math that says knocking out low-interest debt as quickly as possible is a good idea.

However, for many borrowers, it is a good idea.

Eliminating student loans isn’t just about interest rates or optimizing financial assets. It is also about peace of mind. Student loans are stressful, and erasing them feels good.

There are many other reasons to consider eliminating a low-interest student loan:

  • If you are not going to be productive with that money – Borrowers who will use funds for anything other than an investment will be financially better off by continuing to pay off the loans aggressively. The only time someone is better off by just paying the minimum is if they are using the extra money to generate more money.
  • You want to eliminate the payment from your debt-to-income ratio – Borrowers who plan on buying a house may be better off paying off their student loans rather than investing. This is because student debt that is completely eliminated will improve your debt-to-income ratio.
  • It is a variable-rate loan, and you are concerned about interest rate increases – A 4% interest rate may look pretty right now, but if it keeps creeping up, the benefit to investing drops. The longer you expect to take to repay the loan, the bigger the danger of rising interest rates becomes.

Investing Options

Some people might want to just make minimum payments on their low-interest student loans and invest.

Whether or not this idea is reasonable depends on your investments and risk appetite. Putting a bunch of money in Bitcoin or GameStop stock is risky, but for some lucky investors, it has paid off handsomely.

Before jumping into the stock market, student loan borrowers should have an investment strategy in place. They should also be ready to accept the consequences if their investments do poorly.

Putting Other Financial Goals Ahead of Student Debt

Having low-interest student loans makes saving for a house or starting a business easier.

Here again, the decision isn’t an accounting question. It is a question of personal preferences. If you have $15,000 of student loans at 2.5% interest, you spend $31.25 per month to carry that debt. Some people might want to eliminate that monthly interest accrual immediately. Others may choose to live with the monthly interest and get started on other financial goals.

Sherpa Tip: One of the big themes at play here is the concept of opportunity cost. We have finite budgets, and focusing on one goal means others get set aside. The simple explanation of opportunity cost is that it is the loss of potential value from the options not chosen.

For example, if you focus on saving up for a down payment on a house, you pass up on the opportunity to save for retirement or eliminate your student debt.

Essential Step: Locking in the Low Interest Rate

While there are many options for borrowers, those who elect to pay the minimum long-term should take one essential step.

Many private student loans have variable interest rates. The obvious danger to a variable-rate loan is that the rates can go up. Borrowers that want to take advantage of low student loan interest rates to save, buy a house, or start a business are vulnerable to interest rate changes wrecking their plans.

Refinancing variable-rate loans into a fixed-rate loan is an excellent opportunity for these borrowers.

At present, the lowest fixed-rate loans are with the following lenders:

RankLenderLowest RateSherpa Review
1Earnest4.99%Earnest Review
2Splash Financial5.09%*Splash Financial Review
3ELFI5.48%ELFI Review

The borrowers that want to lock in the lowest possible monthly payment and still have a low-interest loan may elect to go with a 20-year refinance loan. This option may help maximize long-term retirement contributions.

RankLenderLowest RateSherpa Review
1Splash Financial6.08%*Splash Financial Review
2Laurel Road6.55%Laurel Road Review
3ELFI6.64%ELFI Review
About the Author

Student loan expert Michael Lux is a licensed attorney and the founder of The Student Loan Sherpa. He has helped borrowers navigate life with student debt since 2013.

Insight from Michael has been featured in US News & World Report, Forbes, The Wall Street Journal, and numerous other online and print publications.

Michael is available for speaking engagements and to respond to press inquiries.

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