aggressive repayment or retirement investment

Should I Pay Off My Student Loan with a Low Interest Rate?

Michael Lux Blog, Strategy, Student Loans 0 Comments

Americans owe nearly two 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 pay off their student loans aggressively.

This aggressive approach is the recommended strategy for most student loans, especially those with interest rates at 8 or 9% or higher. However, 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 if I can afford to pay more?

The idea behind only 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 additional $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 than 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 can tolerate.

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.

Borrowers who think that there is a chance of student loan forgiveness or cancellation may also want to pursue investment opportunities rather than eliminating student debt.

When should I 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 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 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 worry. That peace of mind has real value. If quickly paying off the loan helps you sleep better at night, there is nothing wrong with aggressively paying it off.

Get creative to make the decision easy

A borrower with an interest rate in the 4-6% range may be torn. Retirement contributions might do better than the current student loan interest rate, but there is also a very real chance that they don’t.

Those who are stuck in this position may want to consider refinancing their student loans with a new lender. At present, many refinance rates start right around 2%. Approval for a refinance will depend upon the borrower’s income and credit score, but for many borrowers, securing a low interest rate can open up many new opportunities. Refinancing usually only takes a few minutes, but it is a good idea to know the different lender options and some of the pros and cons of refinancing.

Weighing the options

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

Some borrowers will opt for aggressive repayment, while others choose to save for retirement and eliminate student debt. There isn’t a simple answer to which approach is best, but the student loan interest rate and other financial opportunities will be the key items that can tip the scales in one direction or the other.