Why rush to pay off my student loans if i can deduct the interest?

Michael Lux Blog, Student Loans 2 Comments

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 is smart for trying to take full advantage of the student loan interest deduction.  Unfortunately, there are a number of issues with the student loan deduction that greatly limit the potential value.

Not everyone is allowed to deduct the interest on their student loans

Student loan borrowers are able to deduct up to $2,500 worth of student loan interest.  (Note: a $2,500 deduction does not mean $2,500 less in taxes… it means the government will tax borrowers as though they made $2,500 less in total income)

Because student loan interest is a deduction rather than a credit, borrowers in higher income tax brackets will get more value from the deduction.  This is because the higher earners are expected to pay a larger percentage of their income towards taxes.  Sadly, too much income can mean no student loan interest deduction.

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.

Many borrowers are paying significantly more than $208 per month in interest.  If these borrowers pay extra towards their student loans, it will not affect their deduction.

The biggest reason to ignore the deduction

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.

In other words, the best case scenario with the student loan interest deduction is it makes the effective student loan interest rate slightly lower.  This deduction helps, but eliminating the debt will help far more.

Sherpa Tip:
Borrowers who refinance their student loans are still able to claim the student loan interest deduction.  Student loan refinancing could potentially reduce the value of the student loan interest deduction, but the savings due to lower interest rates will be much larger than the lost deduction.  Sticking with a high interest loan in order to get the deduction would be like paying a dollar to save 25 cents.  The key to keeping the student loan interest deduction is to go through traditional student loan refinancing and avoid any loans that are characterized as personal loans.

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.

Student loan borrowers do have a lot to consider at tax time… unfortunately, the student loan interest deduction isn’t a big factor in this equation.