Yesterday Nate from twitter asked us a great question. He wanted to know why he should be in a rush to pay off his student loans if the interest was tax deductible:
— Nate Gonzalez (@Nateology101) April 5, 2015
There are actually several things to keep in mind about the student loan interest tax deduction.
Not everyone is allowed to deduct the interest on their student loans
The most common reason that people are unable to deduct their student loans would be their yearly income. If you are single and made over $80,000 last year you will not qualify. Similarly, if you are married and as a couple you made over $160,000 you will not qualify.
Even if your income otherwise qualifies, your student loan may not actually qualify. Only loans taken out as part of a student loan program will qualify. This comes into play if you borrowed money from a bank and it was classified as a personal loan.
There is a limit to the interest deduction
Each year you are limited to deducting $2,500 in student loan interest. While that may seem like a lot, if you are paying over $208 per month in interest, it means a portion of your interest payments will not be tax deductible. Depending upon your total loan balance and your interest rate, you could be paying far more each month in interest.
The biggest reason
Even if you do qualify and can deduct all of your interest, just paying the minimum on your student loans is a bad idea. This is because the interest deduction savings on your taxes doesn’t really amount to much money.
The thing to keep in mind is that the interest rate deduction is only a deduction… not a tax credit. If you made $50,000 last year and took the full $2,500 deduction, it would result in a tax savings of just $625. While saving $625 each tax season is definitely a good thing, it still means that you spend nearly $2,000 on interest that you will never get back. If you make less money, the marginal benefit of the deduction is further reduced.
Even if you have two student loans, one high interest and one low interest, mathematically it still makes sense to pay off the higher interest loan first, rather than trying to cash in on the deduction. The math is nicely explained here.
When should the deduction enter into my decision making?
Suppose you had a student loan with an interest rate of 12% and a credit card with an interest rate of 11%. It is conceivable, with this high interest student loan and low interest credit card, that paying off the student loan second is the smart move. This would only happen if the savings on the deduction is large enough to offset the difference in interest rates.
As we saw previously, even with the max deduction, the tax savings is relatively small compared to how much you spend on interest. In some cases, such as two very close interest rates, that small extra savings can make a difference in your repayment planning. Otherwise, it is best to just view the interest deduction as a nice tax perk, and nothing more.