Help a Reader: Pay Off or Don't Pay Off?

Here's an email I recently received from a reader:

I have $21,000 in student loan debt that was consolidated in 2005 and is now sitting at a fixed rate of 1.625% for 20 years (original balance was close to $31,000).  The monthly payments equal $170. 

My question is, with such a low interest rate, does it make sense for me to try to pay it off early, or should I take the money that would go to pay it off and invest it or otherwise make principal payments on my mortgage?  I have no debt other than the student loan and a 30 year fixed mortgage that is at 4%.

What's your advice for him?

Comments

[Jonathan]

Well you certainly should not pay off the student loan ahead of paying off your mortgage. You're spending $325 a year - about $27 a month - on your student loan interest. Assuming your mortgage balance is $100,000 you're paying $4,000 a year or $333 a month in interest on that puppy.

Unless you're very debt averse, I would avoid ever paying off your student loan interest early. That money is nearly free. Other considerations though may include the likelihood you'd ever declare bankruptcy, as the mortgage debt can go away (along with the house) while the student loan debt would still be owed. But since you're considering investing I'd guess you're not living on the financial edge.

[Nick]

I would want it out of my life, but I probably would pay off my mortgage first, especially if it's federally backed in that it can act like another mini life insurance policy in that it can be forgiven at death and a mortgage cannot.

But a fixed rate of 1.65% (simple, I assume) is pretty sweet. In the end, I'd probably pay off the mortgage first though. I know... it's only 4%, but reducing monthly costs frees up much more than money - it gives you flexibility to do what you love no matter what it pays.

If the mortgage is HUGE and something that can't be tackled quickly I'd probably pay off the student loans no matter what the interest rate is to free up the monthly cash flow so I could semi-retire earlier. :)

Way more than math.

[Apex]

NEVER EVER PAY OFF THAT LOAN EARLY. EVER!!

Your mortgage is a clear winner to that loan. Even if your mortgage was paid off you can't get money that cheaply.

Think about it this way. Would you ever invest in anything; stocks, bonds, a business, anything, that told you your expected rate or return over the next 20 years was 1.625%? My gosh, after inflation that is going backwards. No one invests anything in any investment thinking they are going to get 1.625% return over the next 20 years. Maybe in the short term to preserve capital, but over 20 years? I know investments go bad and return negative at times but no one goes in expecting that kind of return.

If you pay off that loan that is not only the return you are expecting, its the return you are guaranteeing yourself.

Would you buy a 20 year bond right now that paid 1.625%. If you do you are saying to the bond seller, here you can have my 21K for the next 20 years. I only require 1.625% annual interest to allow you to keep my money for 20 years. Regardless of what interest rates do or inflation does or anything, you can keep my money for 20 years at that interest rate? Is there a single person reading this site that would do that? The answer is no, because even the 10 year treasury bond pays 1.8% and the 30 year pays almost 3% and I bet no one really wants to buy either of those for 10-30 years either.

If you pay off that loan that is what you are doing. You are making an investment for 20 years (or I guess it's down to 13 now) that pays you 1.625%. If you don't believe you can do better than that over the average of the next 20 years then why would you bother to invest at all?

[Lance@MoneyLife&More]

Unless you hate debt so much that you want to basically lose money don't ever pay off more on that loan than the minimum payment. In a few years savings accounts will have higher interest rates (opinion, not fact) than your loan and you'll be making money off any money that you would have paid toward that loan.

[Nathan]

So, I want to know where to find student loan consolidation at 1.625%. I absolutely HATE debt, but I'd let my $25K in student loans stick around as long as I could, for 1.625%.

Links? Anyone?

[Kurt @ Money Counselor]

Unless you anticipate some extraordinary circumstances in which having any debt whatsoever would be a hardship, don't pay the student loan early.

[Bryan B]

Pay that off as slowly as possible! That low rate should be MUCH LESS than inflation in the foreseeable future. Also MUCH LESS than interest rates you can receive from investing your money in many places even today (and if not today, you could probably get higher interest rates in a few years)

The real Help a Reader should be: how do I get a fixed rate student loan (or re-consolidation) of 1.625%

I wouldn't even mind having $100k of student debt at that price, paying off as slowly as possible.

[Rick Francis]

Mathematically paying off a debt with interest rate R is the same as investing and getting a fixed interest rate of R. A 1.625% loan is effectively putting money in your pocket- you certainly have better things to do with your money than pay that 1.625% loan early. Even a 4% mortgage is fairly low rate of return over a 30 year period.
Instead of paying off that low interest rate debt, you could put that extra more money into your retirement accounts. If you get any employer match on the extra contribution you will do far, far, better. Even using CDs you can get better returns today- a Google search turned up quotes for 1.75% from a 2 year CD and 2.88% from a 5 year CD. You could also invest in VTI Vanguard’s total stock market ETF which currently has a 1.75% dividend yield. This ETF lets you buy essentially the entire stock market, even if stock prices are level for the next 20 years you would still have higher returns from the dividends than paying your loan early.

-Rick Francis

[jim]

I would definitely not pay off a 1.65% loan early. If you want to put extra money into debt then pay down the mortgage. But I don't think theres a strong reason to be in a rush to pay off a 4% mortgage either.

[K00kyKelly]

One thing to consider with student loan debt is that it can't be discharged in bankruptcy. Unlike with other debts, if you experienced an extreme financial emergency and end up in bankruptcy you're just stuck paying it. Probably not an issue for you, but worth mentioning.

As many people have said by the numbers it makes no sense to pay it off early. If you haven't maxed out your Roth IRA put the $$s there and if you're married max out your significat other's Roth IRA too.

[Dan]

My wife and I were in a similar situation and we decided to pay off both of our cars (about $25,000 total at 0%). Even though it might not have been the correct mathematical decision, we had the cash and this decision gave us peace. We're now debt free and we still have enough cash for our emergency fund. Additionally, we wanted the $600 monthly cash flow because we are making career changes (we are both around 30 years old) that may cause temporary drops in income.

[PD]

By not paying it off, you will pay back the lender in dollars that are worth less than they are today due to inflation. In fact, including inflation, the lender is paying you to take the loan.

[Marie]

We had 1.65% but then due to on time payments they reduced our interest rate to 0.65%.

My mortgage is a 15 year at 3.75%. I am leaning towards paying off a portion of our student loans to free up cash flow. We have two separate consolidations though. My husbands is 10k and the payment is doubling next year. I currently make .8% on my savings account and after taxes and tithing on the interest I actually do better paying off the loans than saving it.

My sl's though have a balance of 25k so they will stick around for awhile. I have a 8 month emergency fund, retirement savings, some college for the kids and a Roth IRA for me we put 100 a month in. I see paying my student loan off as part of a diversified portfolio.

The thing about getting into financial trouble is that at least my loans have up to two years of deferment or forbearance due to hardship that I haven't used up yet. So not really a consideration.

[Mark]

@Dan, Nick and others: How can you possibly think it makes sense to pay off a loan to either increase cash flow or fund semi-retirement. Nick specifically said "Way more than math". Baloney - it is 100% MATH!!

For the car loan example: If you want to create this fictitious cashflow, then take your $25,000, stick it in a different bank account instead of the dealers pocket and just pretend you paid off the loean. Then each month, write a check from this new bank account until the loan is gone. At the end of the day, you will have no debt and a little left over - whatever interest you earned in the time the money sat there.

For retirement - you need some lumpsum of money to live off. If you cut your costs by the cost of the low-imterest loan but also cut your lumpsum, you have not got a single step closer to retirement!

You only get ahead by paying off loans with interest rates higher than the rate you will get on your investments. Don't just think of today's rates - look at the full term of the loan. I bet 20 years from now, anyone who slow-paid a loan at 5% interest or less is going to be glad they did.

[Jon]

I have a similar situation. 1.875% for 21K consolidated in 2005. Payment is 118.00/month for 20 years. I am planning on taking the full 20 years to pay it off. Inflation will continue to make the payment cheaper in terms of the value of a dollar. My money can always be used more effectively elsewhere.

[CR]

As one commenter already asked, any help readers suggest in consolidation? Links, etc.?

[Keith]

I would pay it off for one simple reason: freedom. I do not like someone telling me where I have to spend $170 every month.

[savvy]

I wouldn't pay off the student loan early. If anything, I would pay off the mortgage. However, if there is not an emergency fund and retirement savings in place, I would contribute to those before the mortgage.

[Stacey]

I'd pay off the student loan. Mine is at 2.11% has been hanging around for 10 years because the interest rate is so low. I've finally decided that I'd really like the financial peace of having it gone! We call it the 3rd car payment we never get to drive... just tired of it being there for so long.

[Jacob]

Think of it this way... whether you pay off your student loan, your mortgage, or put it into an investment account... they are all "investments". Paying off the loans returns a guaranteed rate equal to the interest rate you are being charged (1.625% & 4%) and what the investment account will earn can vary... 4% guaranteed rate of return is not too bad (its not spectacular either though).

What I would do slightly depends on your situation. Here is the order of importance for where I believe your money should be spent

1. Emergency Fund (If you do not already have it up to ~6 months
2. 401(K) (If you are not already receiving the full match from your employer)
3. Roth IRA (If not already being fully funded, or spouses if you have one)
4. Extra Mortgage Principal

[Rick Francis]

@Marie

> We had 1.65% but then due to on time payments they reduced our interest rate to 0.65%.
> I am leaning towards paying off a portion of our student loans to free up cash flow.

Doing something else with that money will generate more cash flow. I’ll demonstrate with a simple example. Let’s say that you have $1000 cash, a $1000 loan at 0.65% with 5 years remaining and you can earn 1% in your savings account.
The loan payment is $16.94/month. If you pay off the loan entirely you save yourself a total of $16.61 in interest and can stop paying the 16.94/month. That seems like it increased your cash flow but it really didn’t. Here is why: You could leave the $1000 in your savings and withdraw the 16.94/month to pay the loan payment. At the end of the 5 years you would still have about $10 in your bank account because the bank account earns more interest than the loan’s interest rate.
> I see paying my student loan off as part of a diversified portfolio.
Fixed investments can be part of a diversified portfolio, but a 0.65% return is TERRIBLE! Don’t diversify into terrible investments. You can choose a fixed investment with a better rate of return and get a higher return on your money with no more risk. The only advantage to paying off the student loan early is you have one fewer payment to make. Even a 1 year CD will give you about twice the rate of return.

-Rick Francis

[Apex]

A couple common threads on these comments that are in support of paying off loans have to do with increased cash flow and the liberty or feeling of freedom from retiring the debt.

Rick Francis just gave an excellent example of why the cash flow argument seems correct but is not. Paying off an extremely low loan with a lump sum of cash that you have available never increases cash flow. It is not possible to do so as you could have gotten that same cash flow from drawing down the lump sum to make the loan payment just as Rick's example showed.

As to the sense of freedom, I cannot dispute anyone's psychological benefits from removing a debt obligation. I suspect those are very real. However be aware that this is simply a psychological effect, it is not real. That doesn't discount the validity of the psychological effect it can have on you. I just want people to realize that it truly is simply something that feels better but is not actually any better for your finances. It's basically a Net Worth calculation. If you have 30K in cash and 25K in debt you are worth 5K. If you take 25K and pay off the debt you have 5K in cash and 0K in debt, you are worth 5K. As long as you know you are not going to blow the 25K (which for many is a real problem and is why for those people it's always better to pay down any debt but I am presuming we are not talking about those kinds of people), then if the 25K has a very good chance of being used more productively than the cost of the loan then it is better to keep the loan. At interest rates below 2% it's almost impossible to argue that you can't do better with your money somewhere else. And even if you couldn't because you wanted it in very safe CDs or something like that then having access to that 25K in case you needed to do something like put a down payment on a home or pay for a large unexpected expense or whatever the case may be then you have that money and are basically able to use it at the 1.625% interest. If you pay that off and need extra cash for some reason then you either cannot get it or you have to borrow it from a bank at 6-7% or you have to put it on a credit card at 20%.

Paying off the loan almost certainly feels like freedom, but if you traded in a pile of cash for a feeling of freedom you very possibly got a feeling in exchange for an actual decrease in freedom.

[Jon]

@CR

I'm not sure where to look for loan consolidation right now. My consolidation was through Sallie Mae at the time as all of my loans were subsidized federal loans. About 6 months after I graduated, I was just sent paperwork about consolidating all of my loans to a low fixed rate (with an automatic 1% decrease after 36 on-time payments). I do know that the market has changed drastically in the last 7 years and finding loan consolidation at the low rates fro 2005 is basically impossible.
Some of us just got really lucky and hit the sweet spot on student loan consolidation. I have friends who graduated just a couple of years ahead of me who have a totally different situation. As do people who graduated even 6-12 months after me.

[Jonathan]

"Paying off the loan almost certainly feels like freedom, but if you traded in a pile of cash for a feeling of freedom you very possibly got a feeling in exchange for an actual decrease in freedom."

I actually view it the other way around - having the pile of cash and knowing that I only have to pay out of it very slowly on a low-interest, long-term loan is much more freeing than not having that debt. You have TONS more flexibility (read: freedom) with $21k in hand and a 20-year amortization than you do with $0 in hand and no debt.

[Apex]

@Jonathan,

I agree but based on the comments that is clearly not the case for everyone. For some the feeling of freedom seems to come from "not having the debt hanging over your head." I am trying to point out why that feeling is just a feeling and not a reality, for the exact reason you are stating that having the pile of cash with only small monthly obligations gives you more freedom than having no debt and no pile of cash.

It's obvious to me from all the various debt discussions on this board that there are two ways of looking at debt. The business/investment way and the consumer way. If you represented these two views as a ven diagram I think it would look something like this O ...... O. It sometimes sounds like people are speaking two different languages depending on which view they bring to the table when talking about debt.

[Jonathan]

Haha, Apex, your venn diagram made me laugh. Thanks, and you're right!

[Rich Schmidt]

Generally speaking, I agree with all the "don't pay it off early" folks who've already commented. The only reasons I might pay it off would be:

1. If I couldn't automate the loan payment and had to remember to write the check every month. It might be worth the small "loss" in order to eliminate that monthly task I'd have to remember.

2. If it were my last remaining debt (mortgage gone, etc), and I just wanted a clean slate. That might be worth the "loss" to me as well.

For those having difficulty understanding the psychological side of wanting to pay it off, you might want to Google "open loops" along with "Getting Things Done." It's the idea that there's some nagging thing there that needs your attention. Paying off a debt closes that loop and frees up that mental energy. That's why I mentioned reason #1 above. If I can't automate it and have to think about it every month (along with making sure enough money is in that account, making sure I know where the checkbook is for that account, etc), that's costing me energy and attention that I'd rather give to something else.

[Young Professional Finances]

I agree with not paying it off until it's your last debt left. Focus on the debt with the highest interest rates first, then pay this one off. I'm jealous of your low interest rate! My student loans are all around 4-6%. :(

[Luis]

@ Rich No one is misunderstanding the psychological side (read Apex closely). Cultivating a philosophy of smart personal finance is the driving force to positive psychological effects.

Trying to remove all debts in life is practically impossible. One has to own up to the responsibilites of paying all sorts of debt whether it be paying credit cards, loans, retirement contributions, taxes, etc. One cannot avoid any of these taxing issues in life and thus the error lies in one's thinking.

The focus should be to tackle your way of thinking. Employing smart personal finance brings about positive psychological effects that attracts real wealth. Real wealth creation drives the motivation to keep making smart financial choices. Your mental energies are now stimulated, not taxed, by a positive feedback loop!

[Rich Schmidt]

@Luis, I did read Apex carefully. He's a very smart guy, and I value his contributions here highly. He acknowledges that, for some folks, paying off the debt gives a feeling of freedom. I was simply expressing why, to me, it might feel like freedom, and that this feeling may be worth the financial cost.

My reality is very different from the one discussed in this thread. We have 3 mortgages (our home and two rentals), multiple credit cards, etc. But they're all paid automatically every month, and we keep plenty of cushion in that checking account, so I don't have to expend any mental energy at all in dealing with them. Ditto for our retirement contributions, insurance, etc. The annual income tax ritual is the only one you mentioned that requires my attention. (Tracking certain expenses throughout the year goes along with that.)

I want to give my attention to things that bring me joy, help me accomplish goals I care about, etc. Remembering to write a check every month for 20 years isn't worth the money it would have earned me by the end.

[Apex]

@Rich,

I almost commented on your post but didn't. Given the back and forth between you and Luis I did want to add a comment similar to what I was going to say and that is this:

I can entirely relate to what you are saying about automating the payment and removing the mental effort of having to deal with the loan. For someone who had plenty of other options available to them this small savings would also not be that big of a benefit.

I think you probably did read me carefully and I think your post is in line with my thinking. Namely the sense of freedom is in fact just a feeling and not real however the actual savings might not be worth the effort and the hassle which is different than a sense of freedom. The effort and hassle might be the thing that makes the debt feel constraining and as you say be a mental effort that is not worth dealing with.

For anyone who remembers my post about my rules my Rule #1 which is supreme and over-riding of all other rules is simply, NO HASSLES. If the effort to deal with the student loan was a burden and a hassle that was not buying enough benefit especially due to other options that were available to you if you had enough other access to capital then I too would pay it off realizing full well that it was not the best math and not buying me any financial freedom but was simply making my life simpler. I will pay money to make my life simpler because it makes my life better which is what we all are attempting to do with most of our decisions.

I also want to emphasize that when I talked about the psychological value of the feeling of freedom and pointing out it was a feeling and not a real freedom, that if the feeling is overwhelming then getting rid of the debt to get rid of that constraining feeling is also worth it. I just wanted people to realize that they had not bought freedom and that it was a feeling. But if they realize that and still say that feeling is very important to them then that is what they are buying and in that sense, that decision is also valid. They are paying for a feeling in the same way I just said I would pay for simplicity. Neither one is tangible but both can be valuable.

[m.]

Hey everyone - I'm the "Reader". Just wanted to say that my wife and I currently max out our 401(k)s and our IRA contributions each year. We are big savers.

I appreciate all the comments and suggestions and agree that it probably makes sense to keep paying the loan over the next 15 years. The only reason to pay it off sooner would be to achieve the satisfaction of eliminating that debt.

In the meantime, we're going to try to increase our monthly savings over and above our retirement accounts, and pay a little extra to our mortgage to try and get that paid off earlier.

Thanks.

[Mark]

I liked the comment about pay-off reducing freedom, not increasing it. If you don't pay off, you retain the option (freedom) to pay it off later. But if you pay off, you can never go back and say - oh by the way, can I get that 1.65% loan again please?

One of the key principles of good decision-making is to delay making them as long as possible in case further information comes in.

[MonkeyMonk]

I'm late to the conversation but also wanted to add to the "don't pay off the cheap loan" chorus. You're much better off financially to do something else with the money. I'd also probably argue that paying off your mortgage early is negotiable.

I've currently got about 29 years left on a $355,000 refinanced mortgage at only 3.75%. I could pay it off entirely but it would take a pretty big chunk out of my liquid and semi-liquid investments. I feel very comfortable that i've got all my finances in order, so to me, freedom is having that $355,000 available to invest over the next 29 years. I'm betting that I'll be able to beat a 3.75% return over the long-term. Is this risky? Sure, but I'd much rather have access to my funds than having them tied-up in a house.