Student Loan Hack: Don’t pay off your student loan, Invest instead

Michael Lux Blog, hacks, Student Loans 2 Comments

Even though the Fed just raised interest rates, as a nation we are living in a time of extremely low interest rates.  Many student loan borrowers have interest rates below 4%, with some even having interest rates below 2%. This hack is for the people with really low interest rates.

The suggestion to not pay off your student loans does run counter to the suggestions typically offered on this site.  However, from a purely economic perspective, it actually makes sense.

How not paying your student loans generates money

Suppose you owe $10,000 on a student loan with 3% interest.  In addition to having the good future of having rock bottom interest rates, you are also fortunate enough to get a $10,000 bonus at work.  Putting that 10k towards eliminating your student loans seems like an obvious call.  While there are good reasons to pay off the loan, you might end up financially better off if you don’t.

Instead of paying off that loan, you could invest it in the stock market.  For example, you could choose to invest in an index fund.  (An index fund is less risky than just picking stocks and has a number of other advantages).  If you look at the historic yearly returns on most index funds, you will see that more often than not they beat 3%.  Some years they do much better.  If the index fund produces a 7% return on your investment, you come out 4% ahead.

Not only can an investment earn more than the student loan debt, but the interest on your student loans can be tax deductible.  While the deduction isn’t huge, if your investment and student loan end up at approximately the same rate, the deduction could tip the scales in favor of investing.

One way to look at it is that you are investing money that you borrowed from someone else.  Instead of paying off the loan, you are earning interest on someone else’s money.

The Risk

The one big problem with this approach is that you could lose.  The bigger the risk, the bigger the potential reward… but the risk is real.  If your investment loses money, you come out behind.  In fact, if your investment earns less than the interest rate on your student loan, you come out behind.

Each borrower has to decide what level of risk they are willing to accept.  For some, the satisfaction of eliminating a monthly payment is worth just paying off the student loans.  Others are skeptical of putting money in the stock market and just want the security of paying off the loan and saving the 3% interest.

An Added Benefit

However, if you do choose to invest there is one additional perk.  In addition to the potential earnings, there is also an element of added flexibility.  If you put that $10,000 in a fairly liquid investment (meaning you can withdraw the money with some ease), you are protected if you ever need fast access to that large sum of money.

Suppose you need $5,000 to pay for unexpected repairs to your house or your car.  If you paid off your student loan in full, that money is gone forever.  The best you could do would be to go to your bank to try and secure a personal loan.  You won’t find interest rates anywhere near the 2 to 4% that many student loan borrowers currently have.  Alternatively, if you invested that money, you could pull the $5,000 out of your investment account and pay off the unexpected bill.  Either way, you have $5,000 in debt that you didn’t expect, but if you invested, the effective interest rate on the debt is much lower.

The Bottom Line

How you handle your low interest student loans depends entirely on how much risk you are willing to live with.  If you are willing to accept a little risk for the potential of a large reward, investing, rather than paying off your loan could prove to be a good idea.