aggressive repayment or retirement investment

Should I Pay Off My Low Interest Student Loans?

Michael Lux Blog, Strategy, Student Loans 0 Comments

Americans owe well over a trillion dollars in student debt.  Many borrowers end up spending hundreds or even thousands of dollars per month in student loan interest alone.  It is for this reason that many wisely choose to aggressively pay off their student loans.

This aggressive approach is the recommended strategy for most student loans, especially those with interest rates at 8 or 9% or higher, but for low interest loans in the 2 to 3% range, a different strategy may be advisable.  In fact, only making minimum payments on these low-rate loans could be the financially savvy approach.

Why Make Minimum Payments?

The idea behind paying the minimum is opportunity cost.  By paying extra on student loans, borrowers pass up alternative opportunities with those funds.  For example, instead of paying an extra $100 per month on student loans, that money could be invested for retirement.  If the investments earn a 7% return, it is a net positive of 5%.  If that money is being used in a tax advantaged account such as a 401(k) or an IRA, the net benefit becomes even larger.

The risk is that the investments do worse that the interest rate on the student loans.  However, as the student loan interest rate goes down, the odds of success go up.  The question for borrowers to decide is how much risk they are willing to live with.

Ultimately, this approach comes down to making interest work for you rather than against you.  Life with student loans is an uphill battle against daily interest.  Using your money to generate interest turns the tables.

When to Aggressively Pay Off Low Interest Student Loans

Aggressive payment on student loans isn’t necessarily a bad idea.  For some people, no matter how small the interest rate, paying down the debt is the preferred route.

This could be for a number of reasons:

  • If you are not going to be productive with that money – Borrowers who will use funds for anything other than an investment of some sort will be financially better off by continuing to aggressively pay off the loans.  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 2% 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.
  • You hate debt and would rather not owe the money – Some people just want to get debt off their ledger.  One less bill is one less thing to worry about.  That peace of mind has real value.  If paying off the loan quickly helps you sleep better at night, there is nothing wrong with aggressively paying it off.

Bottom Line

As student loan interest rates decrease, the options for borrowers increase.  For the borrowers who have low interest student loans, or those who refinance at lower interest rates, planning for the future might mean paying a little less towards student debt and a little more towards retirement.