21 Mar

Paying student loans early doesn’t always offer the best return

Paying student loans early doesn’t always offer the best return

Fortunately, if you’re having trouble paying, there are built-in protections like reduced payment plans, grace periods, and forbearance-an extreme program in which you may be able to suspend payments for a brief period of time. In some cases, you may also be eligible for partial or complete loan forgiveness if you work in public service.

In this scenario, you have student loans at 5% and have a conservative expected annual investment return of 7%

well fargo personal loans

As we learn about personal finance, writers and experts drive home one point again and again: debt is bad. Avoid debt. Get out of debt as soon as possible. However, in an effort to make sure everybody gets it, we’ve oversimplified the equation. Not all debts are created equal.

I sometimes come across the term good debt and bad debt. Bad debt is bad because it either has a wicked interest rate or is designed to pay for depreciating assets like a car. Good debt is good because it’s used by appreciating or income-producing assets like a business, real estate, or an education.

I don’t like the terms good and bad because it’s hard to call any debt good. A debt may not be bad, but it’s never good. There’s bad debt, and there’s debt that’s OK to keep around because you’re using it as leverage to build more wealth than you could without it.

And that’s how I view student loans. If held to an answer, I tell most people not to repay student loans early. Instead, take that money and invest it. As long as your student loans have interest rates less than 10% over the long run, your money should do better in the stock market than the interest rate on your loans.

Probably investment A. But by paying off your student loans early, you’re choosing investment B. As soon as you make a big loan payment, that cash is gone…you can’t use it for anything else: emergencies, a new home, an investment opportunity, etc. This is another reason I prefer hanging onto extra cash and investing instead of paying off a student loan early.

But…paying off student loans is a guaranteed return, isn’t it?

There’s no way around it: Investing in the stock market is risky. Historically, stock market returns over the long run are stable and may even be as high as an average of 8 to 10% per year. But we all know that today’s economy is uncertain. You could do better, or you could do worse.

When you repay your student loans, you get a guaranteed return. For every additional dollar you pay towards your student loan now, you save paying interest on that dollar for the remaining term of your loan. It’s as good as putting that money in your pocket. This is why, if you have private student loans with high interest rates, it makes sense to repay them early. Although you might squeeze average annual returns of 12% or more out of the stock market, you can’t count on it.

This is where the decision gets tricky: It all depends on the average annual return you expect to earn from your investments and how that compares to your student loan interest rate.

Over 20 years, the difference between repaying your loans early and using that money to invest adds up to $18,000. So even a small difference in expected return and loan APR can add up to big money over time.

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