Many financial planners, myself included, group debts into two broad categories -- good debts and bad debts. Good debts include those that have relatively low interest rates and will help enhance your life. For example, a mortgage allows you to buy a home, which will hopefully increase in value over time. An auto loan (assuming the interest rate is reasonable) helps you buy a car, which can in turn get you to work so you can earn money.
On the other hand, the "bad debts" category include debts that have relatively high interest rates, and/or don’t do much to enhance your life. Credit card debt is the textbook example of a bad debt, especially if it was incurred while buying things you really didn’t need.
I'd classify student loan debt as a form of good debt, but it’s really in a category all by itself. Even though student loans may have slightly higher interest rates as a whole than mortgages and don’t necessarily get you a tangible asset, I’d put student loans ahead of mortgages in many cases. Here’s why:
- Student loan interest, up to $2,500 per year, is tax deductible, even if you don’t itemize.
- There are several ways federal student loan debt can eventually be forgiven. Even if you don’t qualify for Public Service Loan Forgiveness, there are forgiveness programs for other professions (especially teachers) as well as for borrowers who have made a certain number of on-time payments.
- Federal student loan debt qualifies for income-based repayment plans. There are no other debts I know of where your payment can be reduced due to your income without an adverse impact on your credit score.
- Student loan debt may qualify for a deferment or forbearance if you’re experiencing a financial hardship. To put it mildly, if you call your auto lender and tell them you’ve lost your job, you’re not likely to get the same type of treatment.
- Finally, if you obtain a degree, a student loan can increase your lifetime earnings power by far more than its cost.
With that in mind, like most personal finance concepts, there’s no one-size-fits-all answer when it comes to paying student loans early. There are some situations where early repayment makes sense, but others where you’d be better off investing the money or using it to pay down other types of debt.
When paying your student loan debt early is a smart idea
Despite the benefits, accelerating your student loan repayment certainly makes sense in some circumstances. While this isn’t an exhaustive list, here are three situations where it can make sense to direct your discretionary income toward your student loan debt.
- Your student loan debt is at a variable interest rate -- This is rather common among private student loans. Adjustable-rate debt can be quite scary to carry, especially over long time periods. If your student loan interest rates could potentially climb much higher, early repayment could be a smart idea.
- You won’t ever qualify for any type of forgiveness -- This is also true of private student loans in most cases. If your income is too high to qualify for income-based repayment and you don’t work in public service, you also aren’t likely to be eligible for any type of loan forgiveness.
- You don’t want any debts whatsoever -- I can talk about loan forgiveness programs, tax deductions, and more until I run out of breath. At the end of the day, some people just don’t feel comfortable carrying debt of any nature.
When you should pay down other debts or invest instead
- You work in public service and aren’t on the standard repayment plan -- The Public Service Loan Forgiveness program allows the balance of federal Direct Loans to be forgiven after 10 years of qualifying full-time public service employment. However, to receive PSLF, you must be on one of the income-driven repayment plans. Technically, the standard 10-year repayment plan qualifies, but there would be no balance left to forgive. If you feel that you’ll ultimately qualify for PSLF, it doesn’t make sense to pay your student loans down any faster than you have to.
- You qualify for income-based repayment -- All of the income-driven repayment plans forgive any remaining balance if the loans aren’t paid in full after 20-25 years, depending on the specific repayment option. If income-driven repayment is keeping your monthly payments low, it could make sense to use your extra money for other debts, or to invest.
- Your student loans have low, fixed interest rates -- If your student loans are low-interest and don’t have variable rates, investing could be the better option with your discretionary cash.
- You have high-interest credit card debt -- It rarely makes sense to invest or to pay down any of your “good” debts if you have high-interest credit card debt hanging over your head.
The bottom line on student loan early repayment
One important thing to point out is that several of these options could apply to you -- even things from both the “pay early” and “invest instead” categories. For example, it’s entirely possible to have a private student loan that will never qualify for loan forgiveness, but at a low, fixed interest rate.
Every situation is different, so my point here is that it’s important to weigh the applicable reasons both for and against early student loan repayment to make a smart financial decision for you.
