Should I Pay Extra on Student Loans?
This is a common question regarding student debt. If you’re fortunate enough to have room to apply extra dollars towards student loans, excellent. And, if you’ve learned about the benefits of compounding returns on an investment, you’ve probably reached another important question:
With my extra cash, should I pay more on my loans, or invest?
Whenever I hear others talk or write about this question, I’m instantly hooked. As with so much of personal finance, the best option is not necessarily the most optimal mathematically, so the opinions are wide ranging.
One opinion - and it’s not a bad one - is to pay off your student debt, fast. There’s freedom and satisfaction in having that loan balance read $0. More cash is freed up on a monthly basis to use how you want.
Another common piece of advice goes something like this: “If your investment rate of return is greater than your loan interest rate, invest.” That’s not a bad idea either. The trouble with this, though, is the unpredictability of investment returns. If the markets have a good year, and you missed out, with hindsight bias mode engaged, you might kick yourself for not investing. Alternatively, if you stuck to the minimum payment on your loans and invested extra cash, and the market drops, you might kick yourself even harder.
There’s a maybe-but-probably-not-real quote by Albert Einstein: ‘Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.’ Actual saying or not, it’s quoted ad nauseum (I’m a bit embarrassed using it here, to be honest). But understanding how compounding works is nonetheless beneficial.
Let’s think about the “He who doesn’t [understand], pays it” part. (This article has a helpful breakdown of how student loan interest works.)
If I’m making minimum payments on my student loans, am I the sucker? I don’t think so. Because the loan balance is decreasing with every payment, the amount of interest has an upper limit. As long as you’re not missing a payment, the interest is not compounding, and going with the minimum amount only is okay. (Aside: This Bogleheads forum has a debate on whether home mortgage interest, as another example, is simple or compound. It’s interesting if you want to get into the weeds, or need something to help fall asleep.)
Example: $30,000 loan balance at 6% interest, monthly payments over ten years. If making minimum payments, that’s about $333 per month, and in ten years you’ll pay interest of $9,817. Ouch - almost a third of what was borrowed!
However, that $9,817 of interest is a maximum. If you make your payments on time, you’ll never owe a penny more.
Example, modified: Same loan terms as above, but pay an extra $167 per month in addition to the $333 minimum, so $500 total. The total interest paid is much smaller, $5,591, and - a wonderful surprise - the loan is paid in 72 months, compared to 120 months in the first example! That’s a big win.
Now, let’s modify the example further. If you have $167 extra, you could apply it towards your loans and earn that big win. But what if you invested the extra instead? And, what if the investment yields less than 6%, even over a long time period? Let’s assume an investment rate of return of 4.5%, which is historically low.
The conventional advice is sometimes: pay the 6% student loan rather than investing at 4.5%. But those two rates don’t work the same way. As mentioned above, as long as you’re paying down principal every month in the student loan payment, you’re not truly paying compound interest. The interest has an upper limit ($9,817). On the other hand, even an investment with a historically low return of 4.5% has the potential to earn much more over time, because there is no upper limit on future returns. And the sooner you start investing, the sooner the returns compound in your favor.
The chart below shows what happens if you take the $167 in extra cash and invest it rather than apply towards student debt. Over the first ten years, the investment earnings of $4,586 are less than half of the $9,817 of interest expense (again, this is the interest you’ll pay if you only make the minimum $333 loan payments). But do nothing with the amount invested - shut off the $167 per month at the end of year 10, when the loan is paid off - and your investment account balance will work its compounding magic, even if that 4.5% seems rather paltry.
This is one of many ways to show the benefits of compounding, and perhaps a different way to answer the “Pay student debt or invest” question. Missing from the common advice is (1) considering the upper limit on interest expense on a loan and (b) not considering the absolute dollars even a low rate of investment return can produce. Percentages and absolute dollars matter.
One way or another, for those with extra dollars for debt or investing, the best choice is the plan that you stick with. If you can feel the interest expense tacking on to your student loans by the day, there may be no greater psychological financial win than to make an above-minimum loan payment. I’ve done it a few times, and it feels great. What’s more, you can see the benefit of a reduced loan balance within a matter of days.
If, on the other hand, you can’t stand the idea of missing out on compounding returns, applying extra cash towards investments will also feel like a win. The difficult part about compounding is that it takes years to see the effects, so the psychological benefits may not be felt as with paying off debt, but perhaps the table above or something similar will bring about that well-earned feeling of accomplishment.
(Important to note: Credit card debt, in addition to charging high interest rates, does use compound interest. As such, a good strategy for using extra funds is often to pay credit card debt as fast as possible.)
More on compounding:
The Most Powerful Force In The Universe
How Compounding Works in the Stock Market
Underestimating the Power of Compound Interest
Retirement Savings and Compound Interest
More on loan interest:
