Photo by Quince Creative/Pixabay
Introduction
It’s no secret that student loans are the fastest growing category of debt. Sitting at an upsetting $1.7 trillion, student debt exceeds auto loans and consumer debt, second only to home mortgage debt. In 2023, 43 million Americans, or 13% of the American population, owe an uncomfortable $29,100 in student loans per borrower according to a 2022 College Board report.
To achieve financial independence, student loans must be addressed. If you have high-interest student loans, particularly from a private lender, it’s worthwhile to consider refinancing with another lender to lower your interest rate. If you can’t earn a higher return on investment, it’s wise to pay more than the minimum so you don’t pay as much in interest, otherwise investing while paying the minimum is best. Visual reminders of your progress can also help you stay motivated and on track. Below is a comprehensive guide to help you achieve your financial goals even while managing significant student loan debt.
Should We Pay Off Our Student Loans Early?
The knee-jerk response to this question is probably “yes! of course I want to pay off my debts ASAP!” and there’s a lot of good reason for it.
Pros of paying off your student loans early:
- Pay less over the lifetime of the loan — The longer it takes for you to pay back a debt the more interest you’ll accrue. Paying less per month means paying more in total.
- Get a head start on future financial goals — Once you’ve paid back your student loans, the monthly minimum payments budgeted for this cost can go towards other things, like saving for the downpayment of a house, or the stock market.
- Improve debt to income ratio — Generally, 35% or less is considered a manageable DTI. Having a higher DTI can make it difficult to qualify for certain loans like a 30-year-fix-rate mortgage, so if that is your situation, you’ll want to look into paying off your student loans.
- Lowering your mental burden — Being debt free is the first step to financial freedom and the psychological boost of being debt free cannot be understated. Your money is yours and the sooner third party lenders stop taking a cut of your paycheck the better!
Positives aside, you may be surprised to learn that there are sometimes good reasons for sticking with your minimum payments as well.
Cons of paying off you student loans early:
- Higher monthly payments — Committing more of your dollars to paying off debt means less money that can be put towards other things, like investing.
- Take focus away from present financial goals — The sooner you start investing, the more your wealth will grow in the future thanks to compound interest. Depending on your student loan interest and your return on investment, you might get more out of taking it slow with minimum payments.
- Debt forgiveness program — It’s a pretty rare situation, but you may qualify for a debt forgiveness program if you fit the criteria. Do research for your own situation to determine if this might apply to you.
A Thought Experiment
The US stock market has grown at an average of 10% every year since its inception. By buying shares in Vanguard’s S&P 500 broad-based index fund, the average investor can capture this return without much work or stress. Compare that to today’s federal student loan interest rate.
For a term of 10 years, undergraduate students can borrow up to $57,500 for a rate of 5.5%.
If Aaron borrowed $30k in student loans today, should he pay it off early or should he put that money in a broad-based index fund instead? To get the answer, I used the following tools to calculate the student loan, inflation, and stock market return values. Let’s run the numbers.
Aaron decides to pay off his student loans in 10 years:
If Aaron makes minimum monthly payments of $326 and invests $500 in a broad-based index fund, after 10 years…
Aaron will have paid $6,748.19 (10yrs, 3% inflation adjusted) in interest.
Aaron will have $71,153.65 (10yrs, 3% inflation adjusted) in stocks.
Aaron decides to pay off his student loans early:
If Aaron makes minimum monthly payments of $826 ($326 + $500), he will pay off his student debt in 4 years. This means…
Aaron will have paid $2,577.50 (4yrs, 3% inflation adjusted) in interest.
After paying off his student loans, Aaron puts $826 into the stock market every month. After 6 years (subtracting 4 years for the time it took to pay off his debt)…
Aaron will have $56,906.17 (10yrs, 3% inflation adjusted) in stocks.
RESULT: In total, Aaron will have an additional $10,076.79 if he invested $500 for 10 years instead of using it to pay back his student loans early and then investing.
Let’s compare different monthly contribution amounts.
| Monthly Contribution | Pay off student loans early then invest total monthly contribution, result after 10 years starting from first contribution to student loan | Pay off student loans in 10 years |
| $326 + $100 | Stocks: $1,875.12Interest: $5,007.22Earnings: – $3,132.10 (stock earnings did not cover interest cost) | Stocks: $14,230.73Interest: $6,748.19Earnings: $7,482.54+ $10,614.64 |
| $326 + $200 | Stocks: $21,797.48Interest: $4,169.83Earnings: $17,627.65 | Stocks: $28,461.46Interest: $6,748.19Earnings: $21,713.27+ $4,085.62 |
| $326 + $500 | Stocks: $56,906.17Interest: $2,577.50Earnings: $54,328.67 | Stock: $71,153.65 Interest: $6,748.19Earnings: $64,405.46+ $10,076.79 |
| $326 + $1000 | Stocks: $135,401.17Interest: $1,709.87Earnings: $133,691.30 | Stocks: $142,307.29 Interest: $6,748.19Earnings: $135,559.10+ $1,867.80 |
| $326 + $1200 | Stocks: $155,823.67 Interest: $1,806.01Earnings: $154,017.66 | Stocks: $170,768.74Interest: $6,748.19Earnings: $164,020.55+ $10,002.89 |
All numbers are adjusted for 3% inflation, $326 is the minimum monthly payment.
From the chart above, we can see that for a student loan of $30k, it is always preferable to pay off your loans in 10 years rather than early, and invest the additional amount. We also ran the numbers for a $52k student loan at 5.5% interest and got the same result – it’s better to pay off your student loans later than right now.
Something to Note
These results only apply for our input: $30k student loans or higher, 5.5% interest rate or lower, and 10% stock market returns or greater. If any of these values fall outside these parameters for you, our conclusions may no longer apply.
More on the Stock Market.
The stock market is far less predictable in the short term than the long term. From August 7 2020 to August 7 2024, the S&P 500 index fund has returned a jaw-dropping 37%. Conversely, if you bought into the market on Feb 8 2008 and sold Feb 10 2012, you would only see a return of 0.8%. Even investing for a full decade won’t be enough to guarantee you a 10% return.
Getting Organized
Now that we have a rough idea of how we should pay off our student loans, next is figuring out exactly what kind of student loans we’re dealing with.
Private or Federal?
The interest rate and timeline we use above refers to federal student loans. This is because federal student loans make up the vast majority of student loans – of the $1.7 trillion owed, $1.6 trillion of that is federal.
If your student loan is not federal, then it’s private. Generally speaking, private options have a higher interest rate and they’re more flexible than federal student loans. They also offer less protection than federal student loans. This article is an excellent resource if you want to learn more.
List Out Your Student Loans
Before deciding whether to start aggressively paying off your student loans or stick with minimum payments, you’ll want to know the lay of the land. Who are your lenders? What interest rates are you working with? How much do you owe?
If you’re currently in school, you can get this information from your school’s financial aid office. Otherwise, you should be able to gather the information you need from your email inbox. Studentaid.gov is also a great resource.
In an excel sheet, you’ll want to ready the following information:
- Type of Loan – federal or private?
- Lender – which organization did you borrow from?
- Interest Rate – is it more than 5.5%?
- Amount – how much do you owe?
- Loan Term – how long until you pay it off?
- Minimum Payment – also include minimum payment date
- Grace Period/Forbearance Period – federal loans have a 6 month grace period before the first payment is due, certain loans can also be paused or negotiated for reduced minimum payment
With this information ready and on-hand, we’re finally ready to get into the nitty gritty of paying back your student loans.
Pay Back Your Student Loans
Of course, you have been paying back your student loans already, in the form of minimum monthly payments. But how do we optimize this so you’re able to finish your payments quick and snappy.
Step 1) Save up a $1k emergency fund.
Ideally you want enough to cover 3 months of living expenses, but we’ll start with $1k and work our way up. Having an emergency fund allows you to stay the path and keep a level head. Unexpected expenses will happen, from car breakdowns to medical emergencies. Having some money in your back pocket is important for making sure you keep up with your student loan payments in the long term and stick to your plan.
Step 2) Finance Audit
Before you know how much you can set aside for student loan repayment, you gotta know how much you’re earning and how much you’re spending. Take a month to track your income and expenses, then honestly ask yourself: which of these expenses are needs, and which of them are wants?
Once you’re clear on where your money’s going, you’ll be able to figure out how much you can afford to set aside for student loans.
Step 3) Should you refinance your student loans?
If you have student loans with a higher interest rate, and especially if you have student loans with a private lender, it’s worthwhile for you to consider refinancing with another lender to lower your interest rate.
Image from Nerd Wallet
Keep in mind that if you refinance your federal student loans, you will no longer qualify for certain federal protections like flexible loan repayment options, income-based repayment plans or potential future loan forgiveness.
You also don’t need to refinance all your student loans. You can choose to refinance some student loans (e.g. private) and not others.
Final mention — you can negotiate down the offered interest rates! It might take some emailing back and forth, but as the customer, you are within your rights to request price matches and competitive rates.
Step 4) Choose a debt repayment plan that suits you.
There are two main approaches to debt repayment that each have their own pros and cons.
The Snowball Method
Image from Art of Thinking Smart
The Snowball Method starts with the smallest debt. Like rolling a snowball down a hill, after you pay off a small debt, you direct the money that used to go towards that debt to the next smallest debt, contributing more and more as you work your way down the list.
You can also check out the debt snowball calculator if you want to see how this might work with real numbers.
The Avalanche Method
Image from Credello
The Avalanche Method starts with the debt with the highest interest rate then works its way down to the lower interest rate debts. By paying back the highest interest rate debt first, you reduce the total interest rate you pay overall.
To see this in action, try out the debt avalanche calculator, where you can input your real student loan numbers.
Which should you choose?
Both the Snowball Method and the Avalanche Method have their merit.
The Snowball Method is effective because a big part of our inability to pay off debt is psychological. The Snowball Method is a great way to combat that. As you see more and more lines of debt disappear from your ledger, you see and feel the progress, which helps you stay motivated all the way until you’re debt free.
The Avalanche Method makes the most mathematical and financial sense. Paying off your debt this way is theoretically faster and you’ll save more money.
Depending on your own personality and preference, you can go with either of these methods. You can even adopt a hybrid of these approaches, where you start with the Snowball Method to build up momentum and motivation, before switching to the Avalanche Method once you hit the bigger debts.
8 Helpful Tips To Pay Off Student Loans (and other debt!)
Paying off debt is hard! Here are some general tips to help you stay on-track so you can get debt-free faster and be on your way to financial independence!
- Set all your debt payments to be on the same day
By the day, did you know you can call in to your different lenders and request that they change your minimum debt payment dates? You can! And it would be a good idea to do so, if your debt payments fall on different days of the month.
It can be difficult to keep up with all your minimum debt payments if they’re scattered and random. The last thing you want is to miss a payment and have it impact your credit score. Even if you’re set up for auto-pay, it would still help you track your finances and keep everything organized if you make all your minimum payments on the same day every month.
- Contact your lender to make sure your additional contributions are going towards the principal
No matter how much additional monthly contributions you’re able to put towards paying off debt, it’s vital that this additional amount is being put towards good use. If possible, you want to make sure that your additional contributions go towards paying off the principal (original amount borrowed) you owe, not the accumulating interest.
- Know how much you’re getting for your assets
As we’ve shown above, investing now and paying student debt later is the more profitable option, but that’s only if you’re earning a high return on investment. The stock market is unpredictable in the short term and 88% of actively managed mutual funds fail to beat the S&P 500 in the long term.
Here’s our rule of thumb: if your asset is not real estate, and it’s riskier than a broad-based index fund like the S&P 500, then it’s best to liquidate the asset and put the money towards paying off your debt. Once you’re debt free and you have more accumulated wealth, you’ll be able to take on more risk and experiment with stock picking. Until then, it’s better to take the more boring route as you pay back your student loans.
- Keep visual reminders of your progress around the house
It can be hard to stay motivated as you pay off debt. It’s important to keep visual reminders around the house, small post-it note reminders, or agenda task lists, so you stay on-track. One interesting thing you can do is to print out these free debt free charts and color them in every time you pay off a part of your debt.
- Avoid lifestyle inflation fresh out of college
Although the broke college kid lifestyle isn’t ideal, it can be an excellent money-saver. Find a roommate to share an apartment with, continue using public transport, stick with your favorite instant coffee instead of starbucks. Maybe make some grocery adjustments so you don’t get scurvy but other than that, you can continue as you are, in the lifestyle you’re used to, and put your savings towards paying off that bothersome student debt.
- Keep a social circle that understands your new spending plan
One of the most difficult spending categories to control is social spending. You can budget and police your own habits all you like, but all bets are off the moment your friends invite you out to eat.
This is why it’s so important to keep a social circle that understands your financial plans. Explain your plan to pay off your student debt to them and get them onboard. An important part of friendship is understanding our friends’ needs and helping them become their best selves.
- Control the content you consume
There’s no denying it, social media is big on consumption. Whether it’s the stanley craze, your facebook friends posting their latest trip to Japan, or the newest Apple gadget taking the internet by storm, there is always something new to buy, some new enticing way for you to spend your money.
Swapping these out for more finance adjacent content creators like The Plain Bagel on youtube or finding more money conscious online spaces like r/fire and r/personalfinance can do wonders for your media diet, and your wallet. You can even check out more of our own articles like FIRE Budgeting 101, Tax Strategies for FIRE and How to Plan for Retirement in Your 20’s to help you stay on track.
Frugal living habits are much easier to maintain when the practice is normalized.
- Be proud of your wins, don’t compare yourself to others
As wise men say, “Comparison is the thief of joy.” There are people who are fortunate enough to have their degrees paid for by their parents. There are people who may have higher wages but less student loan debt. What matters is not how you’re doing in relation to others, but how far you’ve come from where you started.
Conclusion
It can be difficult to muster up the motivation to tackle student debt. It’s a large sum with a comparatively low interest rate. If I contribute more money will it even make a dent? The interest rate is so low, what’s the harm in putting it off?
We made a case here for the benefit of putting your money towards a broad-based index fund rather than paying off your student loans early, but the principal is the same. It’s only when you invest a set amount every month for 10 years while paying off your student loans that leaving your student loan unpaid becomes justified. The discipline required to do this is even greater than the discipline it would take to pay off your student loan quickly.
For this very practical reason, waiting out the full 10 years to pay back your student loans may not be for everyone. Yes it makes mathematical sense to do so, but human beings are not machines and we all have our own needs and circumstances.
At the end of the day, it’s always worth it to become debt-free. We wish you good luck and godspeed!
