Why You Might Not Want to Pay Off Your Student Loans Early

Should you pay off your student loans ahead of schedule? Here's why this may be a bad idea.

Christy Bieber
Christy Bieber
Jun 29, 2019 at 8:00PM
Investment Planning

Owing money on student loans can feel like a major financial burden. After all, you have to send money to lenders each month and tons of debt shows up on your credit report.

While you may be tempted to get rid of your student debt ASAP by making extra payments and throwing as much cash at it as you can, this may not actually be the best financial decision. In fact, there are a few key reasons why paying off your student loans early might be a bad idea indeed. Here are four of them.

Student in graduation outfit with dollar sign hanging from tassel.

Image source: Getty Images.

1. Federal student debt comes with borrower protections you can't get with other debt.

With most types of debt, lenders don't really care if you're facing financial hardship -- you have to pay back what you owe on schedule. And you can't just change your payment plan to reduce your payment so it matches your income, nor can you expect to get some of your debt forgiven if you do work that serves the public. 

If you have federal student loan debt, on the other hand, there are unmatched borrower protections available to you. Depending on your situation, these borrower protections include:

  • Eligibility to get loans forgiven if you work in public service and make 120 on-time payments
  • The option to put loans into forbearance or deferment, and pause payments if you go back to school, are unemployed, serve in the military, join the Peace Corps, or meet other qualifying requirements
  • The ability to change repayment plans and pick a plan that caps payments at a percentage of income

The government may even subsidize interest on some of your loans during periods when payments are deferred.

Putting extra money toward paying down loans with all these borrower protections rarely makes sense. After all, if you could pay a small percentage of your income for 10 years and get the rest of your loans forgiven because you work for the government or a nonprofit, why pay off your loans early?

2. The interest rates on your student loans may be lower than other debt.

Often, federal student loans -- and even many student loans from private lenders -- have lower interest rates than other kinds of debt. The interest rate on student loans is typically well below the typical interest rate on a credit card, for example. And, it may even be below the rate you could qualify for on a personal loan.

If you have any debt at a higher interest rate, it makes sense to focus on paying off that other debt before paying anything extra on student loans.

And, if paying extra on student loans may put you at risk of getting into other, more expensive kinds of debt, you also shouldn't do it. If you have no emergency fund, you're vulnerable to falling into credit card debt if something goes wrong. You'd likely be better off saving up an emergency fund, rather than making extra student debt payments, so you don't end carrying a balance on a card at a high-interest rate.

3. You could potentially earn a better return on your money by investing it.

When you pay off student loans early, the return on investment you get on your extra payments equals the interest rate of your loans. Chances are good you could probably earn a better return by putting your money into the stock market instead.

Why devote extra cash to student loans when you could get more bang for your buck by investing that money instead? This is especially true if you could invest in a 401(k) to earn an employer match (free money) with your cash. With a dollar-for-dollar match, your guaranteed return is 100%, clearly well above the interest rate you'd pay on any kind of student loan.

You can also score tax breaks by investing in a 401(k) or IRA. The tax deduction you get from retirement contributions reduces your taxable income. This guaranteed tax savings further boosts the chances you'll get a better return on your money by investing it rather than using it to pay off student loans early.

Of course, if your student loans are private loans and you're paying a high rate -- near 7% or 8% -- this changes the calculation. You'll still want to max out a 401(k) to get the employer match. But once you've done that, it may make more sense to pay extra on student loan debt and get this guaranteed return than to take a chance on whether you could actually beat that rate by investing.

4. You'll be giving up a tax deduction (if you qualify.)

When you pay interest on qualifying student loans, you're allowed to take a tax deduction for up to $2,500 of that interest.

This deduction doesn't require you to itemize to claim it, though your modified adjusted gross income needs to be below $70,000 if you file as single, head of household, or qualified widower. The deduction begins phasing out with a higher income. If you hit $85,000 in income with these filing statuses, you lose your deduction entirely. And if you file as married filing jointly, you'll begin to lose the deduction at $140,000 in income and lose it entirely once your household income reaches $170,000.

The tax deduction for student debt reduces the costs of the interest you're paying so it's not a good idea to put extra money toward student loans rather than paying higher interest debt (which usually doesn't have tax-deductible interest) or investing (especially if you score investing tax breaks).

Should you pay off your student loans early?

If you have private student loans, rather than federal student loans, there's a stronger argument to be made for paying off your student debt early. After all, you don't get all the borrower protections available with federal aid and your loans may be at a higher rate than federal student debt. But you still need to consider the opportunity cost -- including the lost tax break and the lost opportunity to do something more lucrative with your cash.

By carefully considering all of your options for how to use your money, you can decide if paying off your student debt early is the best use of spare cash or if the funds would be better used elsewhere, such as to invest for your future. Only after taking this step should you decide paying off your student debt is the right choice for you.