SHOULD YOU PAY OFF YOUR STUDENT LOANS EARLY OR SLOW PAY?
The decision to pay off student loans early or slowly over time is a personal one. There is no one-size-fits-all solution as everyone has unique financial goals, background, and income potential.
I’ll walk you through the factors you should consider, given your personal circumstances, as well as the pros and cons of each choice so that you can make an informed decision.
What does it Mean to Slow Pay Your Student Loans?
Slow paying your student loans means you are making smaller payments over the longest time available in order to free up cash flow over the duration of the loan.
What does it Mean to Pay Off Your Student Loans Early?
Paying off your student loans early means you are making larger and/or more frequent payments to ensure that the debt is paid off faster than what would otherwise be required. This will save you on interest payments over time.
Which one is best for you?
Examining Your Current Finances
The first step in this process is to look at your current finances and assess where you are.
By understanding how much money you have coming in each month, what expenses are coming out and for what, and how much money you have in your savings account (if any), you can get a better feel for where you stand financially.
Hopefully, you’ve done that before getting to this article, but if not, take the time to do it now.
Be Aware of Your Current Debt
A tool that will help you to do that is to create a list of any and all debt you have. This includes all consumer debt (credit cards, personal loans, store loans, and non-secured lines of credit), Secured Loans (auto loans, furniture loans, mortgages, etc.), Student Loans, and/or any private loans (loans from family members or other individuals).
You should be aware of the balance for each loan, the minimum monthly payments as well as its interest rate.
We have several worksheets available to help you track your debt payoff.
Do You Have an Emergency Fund?
It is important to have an emergency fund. An emergency fund is generally defined as 3-6 months of expenses, but the more you have the better. If your income is variable or unpredictable, then having an emergency fund of 12+ months of expenses would be ideal.
If you do not have an emergency fund this factors into how much extra you have available to pay on your student loans, at least in the immediate future. At least in the interim, your emergency fund should take priority over early student loan repayment.
Your emergency fund is your safety net for unexpected financial catastrophes like job loss, illness, and divorce.
Are You Saving for Retirement?
It’s important to consider whether or not you are currently saving for retirement. If so, how much are you contributing on a monthly basis? Another important question to consider is whether or not your employer offers a matching contribution? An employer contribution offers an immediate 100% return on your investment up to the amount of the employer match and should not be passed up in most circumstances.
You can start this process by signing up with your employer to have money taken out of your paycheck on a yearly basis if you haven’t already. If not, it’s never too late to start as time is your ally when it comes to retirement.
In the bigger picture, knowing how much money you’ll need for retirement will help you to make better decisions. Knowing your financial goals, both in the short and long term will help frame your next steps.
How Much Do You Need to Retire?
Two things will determine how much money you need to save to retire; when you want to retire and how much you anticipate your annual living expenses to be.
Of course, external factors like inflation and unexpected occurrences (like catastrophic illness) may require you to adjust your plans; however, for this exercise, we will speak in generalities.
Also, whether or not you have additional income sources like social security, a pension, residual and/or business income will reduce how much and how long you need to save overall.
The measure we prefer to use to determine what you will need to retire is your FIRE number. FIRE stands for, Financial Independence Retire Early, and your FIRE number is the measure generally accepted by those in the FIRE Movement.
Your FIRE number is defined as calculating 25 times your expected annual expenses at retirement. Once you have accumulated this amount, the theory is that your investments will generate enough income for you to live the rest of your life without running out of money. This strategy was made popular by the Trinity Study and has been discussed and tested at length.
Here’s an example:
You believe you can live on $40,000.00 per year once you retire. You currently live on about 20% more than that but also live frugally, will be debt-free when you retire, and intend on living in a low-cost living area.
$40,000.00 X 25 = $1,000,000.00
Accordingly, you will need to have $1,000,000.00 saved when you retire. One million dollars in investments should, on average, earn enough interest to produce at least $40,000.00 in income needed to live on during retirement.
We like the Retirement Calculator at Personal Capital. It is FREE (the best type) and it allows you to implement multiple scenarios so you can plan better.
What Are Your Financial Goals?
Once you know where you stand financially, it’s time to think about your financial goals.
Whether or not it is in your best [financial] interests to pay off your student loans early or slow pay them will greatly depend on what your financial goals are.
Do you want to retire early?
Do you dream of living abroad?
Is working as a digital nomad and working remotely appeal to you?
Does your debt prohibit you from envisioning any of these financial goals?
What about paying for college or creating generational wealth for your children?
These are all important considerations and are specific to each person.
Making a Plan to Pay Off Your Student Loans
Now that you know where you are financially and where you want to be, you can now begin devising a plan to get there.
Having a plan, being proactive about it, and making sacrifices today will result in significant gains down the road when all is said and done.
First, determine if your financial goals are supported by the choices you are currently making given your present circumstances. Do you need to make changes and what do those look like? Do you need to increase your cash flow? Eliminate debt? Etc.
Secondly, determine if paying down your student loan debt will help you pursue your financial goals. It may not always make the most financial sense to do so. We will examine how to determine what is best for you in just a moment.
Thirdly, always remember time and compound interest are your best allies. So, the sooner you implement your plan the greater your returns will be.
Finally, keep in mind it is also never too late to make good financial decisions. Start now, wherever you are.
The Benefits of Paying Off Your Student Loans Early
It Will Cost You Less Over Time to Payoff Your Student Loans Early
The biggest motivating factor to paying off your student loans early is that you will pay less interest over time by doing so. Simply, you will pay less by paying them off faster.
This is not always the case, however, so it is to your benefit to experiment with repayment calculators to see what makes the most sense for you.
You can use the calculators at StudentAid.gov to determine how much interest you will pay on your loans given different scenarios, including early repayment, income-based repayment plans, consolidating and utilizing student loan forgiveness programs.
Your Overall Credit Picture Mays Improve When Your Student Loans are Paid Off
Another reason to pay off your student loans early is that your credit score/portfolio may improve.
Your credit score is determined by five different factors [insert internal link]; payment history, credit utilization, mix of credit, age of credit, and new applications for credit.
Improving your credit score and/or portfolio may be important to you, especially if you are looking to make a major purchase, like a car or a home in the near future.
The major reason is that it will decrease your overall debt-to-income ratio. Simply, you have more disposable income available making you less of a risk to potential lenders.
You Have a High-Interest Rate On Your Student Loans
If your student loan interest rates are high, you may reduce the amount of interest you pay over time by paying off your student loans early. Once your loans are paid off, that money can go to work for you.
As a simple example:
Student Loan Balance = $100,000.00
Interest Rate: 4%
Years Left on Repayment: 10
Monthly payment: $1012.45
Total Interest Paid: $21,494.17
Student Loan Balance = $100,000.00
Interest Rate: 4%
Add Extra Monthly Payment: of $2,000.00
Total Interest Paid: $6,155.34
That is a savings of $15,338.83 over the life of the loan and you shave 7 years off of your loan.
If you then were to invest those monthly payments of $3012.45 into the market with an average annual rate of return of 8%, that money would grow to an incredible $336,317 in the remaining 7 years!
(We used the calculator at Bankrate for the above scenarios.)
You Do Not Qualify for Student Loan Forgiveness
It may make the most sense to pay off your student loans early if you do not qualify for student loan forgiveness.
Some of the reasons you may not qualify for the Student Loan Forgiveness Program (PSLF) are:
- You have private loans
- You are not employed in a qualifying field. (To see if you qualify for the PSLF program you can click here.)
- You are not in the correct type of loan
One of the most satisfying reasons to pay off your student loans is the satisfaction of knowing they are paid off. The stress of having student loans hanging around your neck for years and years can take its toll.
Even if it does not necessarily make the most financial sense to do so, sometimes the psychological benefits of eliminating certain types of debt outweigh any monetary benefit it may bring to pay them off early.
The Benefits of Slow Paying Your Loans
There are two considerations that impact your decision on slow-paying your student loans or not. One is pure math and the other is the psychological impact of paying off your student loans versus other options.
Factoring Student Loan Forgiveness Into Your Student Loan Repayment Plan
There are multiple avenues for Student Loan Forgiveness. Whether or not you qualify and for which plan should be something you consider when determining whether or not you
Your Investments Mays Earn You More Money
If your student loan interest rates are low, you may not save much money by paying them off early.
Over the last decade, the return of the market, coupled with extraordinarily low student loan interest rates, has meant extra income going toward debt repayment would have been better served in the market.
This may not remain the case; time will tell. If all else is equal, it makes more sense to invest that capital than pay off your student loans early.
You Need the Extra Cash Flow for Other Funds
It may simply not be practical or wise to pay extra towards your student loans now. And that is OK!
You Do Not Have an Emergency Fund
For instance, if you do not have an emergency fund, any extra cash flow should be going towards building your emergency fund first.
Your emergency fund is your life-preserver. Much like putting your oxygen mask on first before your child when flying, your emergency fund is what will help you weather a financial catastrophe and is priority number one.
You Are Behind in Your Retirement
If you are behind in your retirement funding goals, that should also be a priority for you. Particularly if you are already behind in your savings. If you are unsure of where you are in your retirement goals, go back through the exercise above and see where you are. Or you can use the retirement calculators at Personal Capital.
You Want to Pay Off Your Mortgage First
If you are saving for another important goal, paying off your student loans may not be the priority. Saving for a down payment to buy a home is one example.
Another might be that paying off your mortgage is more important to you, psychologically, than your student loans. Being mortgage-free and having the safety of a paid-for home may be the better choice for you in the grand scheme of life.
As you can see, there are many things to consider when it comes to paying off your student loans.
Whether or not you’re going on the slow-pay plan will depend on how confident you feel about your current financial situation or whether it makes the most sense to pay your loans off quickly. We hope that we have given you the important tools you need to make the best financial plan for your circumstances!