I’m surprised at how often this question comes up. Normally it is in the context of “I owe X dollars, and I have X dollars sitting in the bank, should I use it all to pay off my student loans?”
The answer to this question is almost always just to pay off your student loans. However, most people think they fall into some exception that makes their situation different. Most people are wrong.
I’m going to haggle with my lender, offer to pay in a lump sum, and save some money…
No you are not. You may have heard about people settling their debt for pennies on the dollar, but you are likely in an entirely different situation. Have you fallen behind on your student loans? Does your phone keep ringing off the hook? Has your debt been sold to a collection agency? If you answer was no to all of these questions, then you are in no position to “haggle” to get a lower payoff amount.
The ideal borrower in the eyes of a student loan lender is someone who never pays more than the minimum, occasionally pays a late fee, but doesn’t ever fall behind. This is when the income for companies like Sallie Mae is the highest. If you are caught up on your student loans, it means they are making money on you each month in the form of interest. They don’t want you to pay off your loans with a lump sum, and they certainly won’t be giving you a discount to do it.
I can earn more money by investing…
This may be true, but you are playing with fire. I will be the first to admit that student loans have made me very debt-averse. Anytime I can eliminate some debt, I will look to do so. However, from an objective standpoint, it is conceivable that your money could do more for you in an investment.
The problem is that you really don’t know. Student loan interest is never lower than the interest on any banking or money market account, and you will almost never find a CD that has a higher rate than your student loan. Why is this significant? It means that whatever investment you choose will involve some risk.
Suppose you expect to earn 8% in the stock market, and you have student loans at 6.8%. You cannot just say that 8 is bigger than 6.8, so I’m going to invest. The question is this, would you rather a possible gain of 8% or a guaranteed return on your investment at 6.8%?
The fact that paying off your student loans is the equivalent of a guaranteed return on your investment makes it a very compelling decision… not to mention the psychological relief that comes from being student debt-free.
The one factor that can shift the investment equation is retirement savings — especially if your employer will be matching. Borrowers in this situation will want to spend some time optimizing their saving and debt elimination strategy. Fortunately, it is possible to plan for retirement and eliminate student debt at the same time.
I’m saving up for a home…
Being able to put a bunch of money down is a great thing, but the reality is that paying off your student loan debt will likely give you far more home buying power than a deposit. If you have student loans and you want to buy a home, one of the big obstacles could be your debt-to-income ratio. If you can wipe some debt off the books, your DTI will improve, and your borrowing power will increase dramatically.
Buying a home is a huge priority for many, but the decision has to include many factors beyond simple economics.
The best reason to put off paying off your student loans…
The most logical reason not to make the huge lump sum payment is that you don’t want to lose your rainy day fund. It is a good idea to have at least several months worth of bills squirreled away. Nobody plans on being fired or running into huge medical bills, but it happens every day. If you want to protect yourself a little, having this money set aside can be a good idea.
How do you decide which is better? Do the math. Suppose you have $10,000 in student loans, and you have $10,000 in the bank. You want that money in case of an emergency, but don’t know if it is worth it. Look at how much money you spend each month on student loan interest. Suppose it is $50. Are you willing to spend $50 a month to have that money sitting in the bank in case of an emergency?
The Bottom Line – Most of the time you should just pay them off
Student loans suck. If you can get yours paid off, do it. Don’t make excuses, just get it done.