I know we’re all about saving money around here. Then again, who isn’t?
Whether it’s to up your retirement savings or to save up for your next big trip, having more money is always a good thing.
What about your student loans? Clocking in at around $1.5 trillion, student loans are a massive liability.
Many people simply pay the minimum due to relatively low payments, interest rates, and federal protections (on federal student loans).
But what if just a few percent in interest were enough to cost you thousands in the long run? Unfortunately, it’s true – even if your interest rate is low.
As a result, it’s best to repay your student loans as quickly as possible. Of course, not everyone will be able to do so. But if you have the luxury, I highly recommend it.
Read on to find out how paying off your student loans could save you money.
By the Numbers
One of the main reasons people continue to pay the minimums on their student loans is because they don’t realize how much it’s really costing them. But when you see the real numbers, you start to understand what this all actually means.
To give an example, let’s say you’re the average student loan borrower. For the class of 2018, the average student loan debt is $29,800. We’ll also use the average interest rate for federal student loans in 2017-2018, which was 4.45%. In addition, we’ll assume we will make payments for 25 years as many federal student loan payment plans are eligible for forgiveness at that point.
If we plug all of these figures into Student Loan Hero’s calculator, we see that we pay $19,045 in interest alone and the total repayment amount is $47,945.
But the really important thing to understand is the effect of compounding. This is usually mentioned in the context of investing, but it also works in reverse, when repaying a loan. After all, the lender is “investing” in student loans.
So, if we use all of the above numbers in the calculator again, but reduce our payment period to 12 years, what happens? Here’s the crazy part: the monthly payment is less than double, but thanks to compounding, the interest we pay is much less than half: $8,452.
We just cut the total amount of interest paid by almost 66%!
PLUS (Interest) Loans
Now let’s make things even more “fun” and suppose we had funded our education with Parent PLUS Loans. Mainly because that was a large part of my loans, but also because I am not the only one.
The average interest rate for these loans is currently a whopping 7.6%. I went to a private school and my loans were near $100k. However, I also had some Perkins and Stafford loans.
So, let’s just say we have $75k in Parent PLUS Loans paying for 25 years.
The result? Monthly payments are $559. As for the interest, that comes to a mind-boggling $92,739.
That’s right – the interest is more than the original principle.
Now let’s take that down to 12 years again. Because of the high interest rate, there is a smaller difference in monthly payments – $559 for 25 years vs. $795 for 12 years.
However, the interest saved is absolutely staggering. Remember, we were paying $92,739 in interest over 25 years. When cutting it down to 12 years, the total interest becomes $39,549.
Now, that is still a lot of money – don’t get me wrong. Still, the difference of $53,190 is basically enough to buy a tiny house. Or a really nice car. Or whatever you want because the money is yours now!
Investing the Difference
Are you ready for this one? If not, strap yourself in, because things are about to get even crazier.
The last example was more extreme, so we’ll go back to using the averages. Remember, that meant paying $8,452 in interest over 12 years compared to $19,045 over 25 years. In this case, you are saving $10,593.
For the average student, that means you will be 34 years old when you’re 12 years out of college. Let’s say you invest that $10,593 in a pre-tax account starting at 34 and don’t touch it until retirement.
Currently, the retirement age is 66, so our money has 32 years to grow.
Even if we don’t add a single dollar to the original $10,593, it will grow to $92,321 over 32 years if we assume a 7% rate of return.
How crazy is that?!
By simply paying off our student loans more quickly and investing the difference, we end up with an extra $92,321 by the time we retire.
Small Percentages Matter
This is an economic concept that is often stressed in the personal finance community. I remember that I was able to justify investing in Fidelity’s FZROX over Vanguard’s VTSAX after I ran the numbers. Keep in mind that the expenses on VTSAX are a measly 0.04%.
Still, after running the numbers through an expense ratio calculator, I was finding that avoiding that 0.04% could save me as much as $36,000 in my lifetime.
And that is the concept I want to drive home here. Don’t assume that because the interest on your student loans is “only a few percent” that it doesn’t matter how long you spend repaying them.
Of course, everyone’s situation is different and we won’t all be able to repay our loans quite so aggressively. At the same time, I certainly would never recommend that you pass on basic needs because it will pay off in the long run. We all have to eat.
My Recommendation: Budgeting + Automatic Payments
The idea here is simple.
For most of us, it’s important to have a monthly budget to be sure we keep our spending in check. Of course, your minimum student loan payment should be one of your budget items.
But the next time you make your budget, figure out if there is any money left over. If you’re lucky enough to say there is, roll some or all of that money into your minimum payment.
Then, set up a recurring, automatic payment with your loan servicer with that combined amount. It’s often said that we don’t miss the money we don’t see.
If you make it automatic and don’t think about it, you’ll be less likely to mess with your payments going forward.
And that, my friends, is how paying off your student loans could save you money!