Thought this is the best place to start a fun debate on this subject.
Situation:
No mortgage, effectively zero CC debt, etc. ‘Large’ student loan balance @ 6.25% interest.
Options:
Refinance to variable 5-year rate, significant savings on headline interest rate (6.25% to 3.80% current)
Same as #1 but add an extra payment each month of lets say 1,000 to 1,500 to pay off the balance <2 years
Same as #1 but instead of the extra payment of 1,000-1,500 into the student loan principal balance put this recurring amount into some sort of ‘safe’ investment. Let’s say LendingTree and the assumed return is 4-5%.
In theory option 2 and option 3 should result in the same net benefit. Option 1 benefit is less interest outlay, whereas options 2 is same interest outlay offset by interest income taxed at my current income bracket.
Oh also, the interest on the student loan isn’t tax deductible
If your safe investment isn’t earning more than you are paying for the student loan debt (after taxes), then go ahead and pay off the debt. That’s a no-brainer.
One advantage of paying down debt is that you more or less know exactly what the return on your investment will be. Although unexpected inflation rate changes can make you wish you’d done one thing or another, in traditional analysis terms, there is almost zero risk to you in paying down debt. That’s not 100% true, but it is mostly true when comparing to returns of assets like stocks. So the sharpe ratio on paying down your personal liabilities is pretty good, both in relative terms and often in absolute terms. Also, your returns in the form of reduced liabilities come to you essentially tax-free, which makes them more attractive.
of the options you suggest, if you are thinking of paying down principal through extra payments, it may make sense to refinance the loan and then go ahead and make the extra payments of you are disciplined enough to do it. The variable rate and the fixed rate are likely priced to yield the same returns over some time horizon of loan life, but if you can pay it off faster, you’ll likely come out ahead, barring some dramatic interest rate spike. But if you think you’ll have the balance paid off in 2 or 3 years, it seems unlikely that that is going to happen, and if it does, you’ll be paying interest on a reduced balance because of extra payments and you’ll also have a bit of a margin of safety because the variable rate loan’s initial rate is lower than the fixed loan.
if you discover along the way that you have a better investment for the money, you can stop making the excess payments or acquire debt from other places.
The only cases where it makes sense not to pay down your debt is if you see another need for similar amounts of money (like starting a business, or some other high-paying investment that has acceptable risk to you and beats the loan’s interest rate) but are not going to be able to borrow at rates similar to or below what you are paying on the student loan. In that case, you will hold back on the student loan so as to free up cash for these other purposes, and effectively pay the student loan rate on money you are using to take advantage of this other opportunity. This makes sense if you need the money for some productive purpose and cannot borrow elsewhere at a rate better than your student loan.
Either way, it seems sensible to refinance, though that will also lower the hurdle rate you have to beat for alternate uses of cash
Depending on your tax bracket, you may be able to invest in LendingClub and make it work. But that spread would be thin and probably not worth it. 6.25% after tax is a really high hurdle in the current rate environment
Refinance it. Student loan rates are usually one of the cheapest rates. similar to mortgage and auto rates. These are the good kind of debt. Floatings rates are usually never an issue. if rates rise pay it off. (assuming of course your salary is 2x greater than your debt.
As a general rule, anything above 5%. I’d pay off.
Thanks for the replies, good insights here which is what I expected.
I wanted to add i’ll be refinancing the student loan either way, as some have indicated the 6.25% is a really high rate. I actually already refinanced last year from a 7% ‘government’ rate to the 6.25% Sofi offered. Within 1 year rates have completly imploded which I suspect is due to the loanable funds market moving away from banks and toward originators which has enhanced market liquidity.
Bchad-
I think part of the equation im considering is the inherint risk of applying extra payments. These extra payments could be part of my short-term cash cushion if something unexpected happens to my health,job etc. I might end up doing a lower exta payment option and put the rest into something short-term with okay liquidity if I really do need access to the funds. The 3.8% i’ve been quoted is a pretty small hurdle rate, I could probably lock in 4-5% yield through a long position in a utility offset by a rolling 12-month put for the next few years. Benefit here is a small pickup in yield and access to capital if I desperately need it.
You balance the risk of needing the cash with the cost to acquire it. Do you have no other sources of credit that you can tap if you’ve paid this loan off? That seems unlikely.
Granted, alternate credit is likely to be more expensive than student loan debt, and possibly not tax deductible. But presumably if you are thinking of paying it off, your chance of needing that credit in the next few years (for something real, like starting a business or a medical emergency) is relatively low, so you balance the difference in the interest rates with the likelihood that you are going to need that cash.
Whatever you choose, it seems like refinancing to a lower rate is a good idea.
EDIT: your thread was titled “pay off debt or invest,” so that’s the perspective I was taking. If you don’t have a rainy day fund, then yes, building that up is a defensible reason not to pay down your debt, particularly if you don’t have access to other sources of credit.
CvM and I are probably on the same page here…pay down your debt. Screw expected return vs interest rate. Get that debt off your back ASAP and free up that cash flow.
Sofi is great, big fan of what they’re doing. Their website is really easy to use, it’s fast and painless in comparision to other vendors. I would recommend to family and friends.
SWL, I think you’re right. I’m just going to go after the principal balance and not necessarily worry about what I could be earning on those extra payments in the market. Maybe i’ll beef up my savings account a bit more before I begin the prepayments, acheive some additional peace of mind.
Initially I +1’d it. But then I started thinking, and I wanted to add those two points, because that makes student loan debt relatively less sinister than other debt.
And I just had a discussion with somebody offline about the merits or demerits of the CFP program. Maybe that’s why I’m harping on it today.
To clarify, there is no tax benefit for me as the deduction scales down as income increases. Like you said it’s maxed at 2,500 deduction which (as an example) at a 15% tax bracket is only a $375 annual benefit.
Interest paid on large loan in $ well exceeds the $375 tax benefit.
And the death benefit part is really awkward. Keep debt around because I might die and my family won’t have to pay it off? Life insurancy policy sounds more appropriate than keeping a high interest student loan around.
^I had never done the math, but your comment spurned me to look at it further.
The tax benefits begin to phase out at $130k (MFJ) and are completely phased out at $160k. ($65-80 for single.) So the greatest possible benefit would be at the 25% rate. At a $50k student loan balance, the greatest possible net benefit would be $625, or about $50 per month. (Assuming a 6.8% rate and max deductability is $2,500.) So you’re right, it’s probably not worth holding onto just for the tax benefits.
And I don’t really know how much $50k of life insurance would cost per month. For a healthy 20-something, I would imagine it would cost less than $20 per month.
So the tax/death benefit at $50k in student loans is less than $75 per month. I probably spend more than that on ice cream and bubble gum every month.