Should I pay off my student loans with a huge lump payment?

Michael Lux Blog, Student Loans 4 Comments

We just received another reader email with a great question that many people likely face.  With today being the Fourth of July, it seems an especially fitting question to address.

I have been paying off my Sallie Mae student loan for more than 15 years now.  It’s never posed a hardship and I can be lazy about financial issues so I just let the automatic deductions roll out.  I don’t have any financial hardship that would allow me to take advantage of the rate reduction you write about elsewhere on the blog.  But I have made my payments regularly and on time.  Is there any sort of loan reduction reward for that? 

If not, under what circumstances do you think it would be best just to pay off the remainder of the loan?  I’m in a position to do that right now though it’s a rather large sum so I’m wondering if that would be smarter than continuing to pay interest.  Thanks for any advice you can offer.

It sounds like you are in a great financial situation.

To answer your first question, there really isn’t a reward for paying your loans regularly.  Your reward for timely payments is not getting hit with late fees.  The closest thing to a reward for timely payments would be the .25% rate reduction for automatic deductions, but is sounds like you should already be getting that.

If you are in a position to just pay off your loan, that is likely going to be your best choice.  It comes down to a question of the time-value of money.

A quick example

Suppose you owe $10,000 on a student loan and have 3 years worth of payments before it is paid off.

It may seem reasonable to just pull the monthly payments from your savings, even if you could pay it off up front.  However, doing so comes at a very high cost.  Even if you have a low interest rate on your loan, say 5%, you will end up spending nearly $800 in interest over the next three years.  That is $800 in profit for Sallie Mae, and $800 that you could have kept for yourself.  If the interest rate on your loan or the balance is higher, the numbers are even more staggering.

What the question comes down to…

If you leave your money sitting in a checking account it is earning 0% interest, while the interest on your debt continues to grow.  The only way it would make sense to not pay off the debt is if you could use that money to earn a higher interest rate.  If the interest you are earning is greater than what you would be paying Sallie Mae, it would make fiscal sense not to pay it off.  Otherwise, pay off your debt.

Other considerations

It might also be reasonable to hold off making a huge final payment if you are using that money as a “rainy day fund” or something similar.  Most financial professionals recommend setting aside at least several months worth of living expenses should your run into job loss, a medical condition, or other unexpected expenses.

If you want to leave the money in the rainy day fund, it is a justifiable decision.  However, it is important to remember that it comes at a cost.  Figure out how much you will be spending in interest if you continue to just make the monthly payments on your loan.  Look at that number and ask yourself, “Am I willing to pay this price for the added financial flexibility?”

About that reward you asked about…

There is a huge reward to making a huge final payment.  Not only will you save hundreds in interest, but you will be free from Sallie Mae.  That freedom is definitely something to be celebrated.  No more monthly payments, no more interest, no more stress!

You have a shot at this freedom and the means to make it a reality.  Go for it!