Sometimes I hear people talking about how they’re not paying off their student loans because the interest rate is “so low that it’s not worth worrying about.” Even if they have the money on hand to repay it.
Something about that just seemed off to me. I spent some time with a few calculators (including my Pay Off Debt app) to puzzle it out.
What I found might surprise you.
Why many people don’t worry about student loan interest
Let’s talk about the two major types of thinking behind not paying extra on student loans. Basically, people who choose not to pay extra when they could seem to break down into two camps:
- those who aren’t doing so because they’re focusing on paying off other debt first,
- and those who aren’t doing so because their student loan interest rates are low
Those who focus on other debt first
If your focus is on getting out of debt, you may just not have gotten to your student loans yet.
In that case, it’s just a matter of time until you get to them. You’re not actively avoiding paying them off, you’re just paying off debt that’s higher up in your list first.
Those who have low student loan interest rates
From here on out we’ll talk about this second group: those aren’t in a hurry because their student loan interest rates are low.
According to the Federal Student Aid Office, the rates for loans that were disbursed prior before July 1, 2017 range from 3.4% to 8.5%. You may believe that you can earn more money by investing it instead. If math is your reason for not worrying about student loans, you might not be being as logical as you think.
Let’s look at some numbers
Suppose you magically have $10,000 to invest right now. You also have a $10,000 student loan balance that you took out at 6% interest annually. If you decide not to pay the loan off in full and invest the $10K you have on hand instead, what might happen?
Due to the magic of compound interest, if you have $10,000 upfront that you earn 8% per year on, you will end up with about $46,610 total at the end of 20 years.
You would also have paid about $17,194 toward your student loan, leaving you with a $29,416 profit between the two. Not bad, right?
20 years to make $29,416.
That’s if everything goes perfectly, meaning you can always earn 8% a year on your investment and you never miss a payment or incur a late fee on your student loan.
How realistic of a scenario is that?
If you’re not worrying about your student loan because of the low rate, have you:
- actually invested the total amount you borrowed?
- at the same time that you borrowed it?
- at a guaranteed 8% return per year?
- that you know you’ll get every single year in a row for 20 years?
Probably not. We can’t see the future, and as the saying goes “past performance is no guarantee of future results”.
Another scenario involves faithfully investing the excess that you could be sending to your student loan every single month. (Rather than doing something else with that money.)
But again, how many people actually do that? And if you ARE doing that, have you run the calculations compared to what would happen if you paid off your student loan early WHILE also investing along the way? And then investing even more once your loan is repaid?
I’m sure some people have, but I suspect they are few and far between.
A more likely scenario is this:
Joe Student takes out a student loan for $10,000 at 6% interest. 4 years go by while he makes his monthly payments and doesn’t worry about it. After 4 years, he still owes $9,123, but has diligently paid $3,438.72 toward the loan. During those 4 years, he buys a house and manages to pay off the credit card debt he racked up in college, so his only debt beside the mortgage is the student loan.
One day he gets a $5,000 windfall and thinks, “Hm, should I pay this toward my student loan? Nah, that’s at such low interest rate it’s not even worth worrying about.”
He treats himself by spending half the money on something fun. He invests the other half responsibly. After 16 years, he pays off his student loan (to the tune of about $17,194.) He also has $8,565 in investments from that $2500 investment. (He earned 8% every single year on it for 16 years.) He’s relieved that he finally doesn’t have a monthly student loan payment anymore. He starts thinks about buying something else over time with the extra money.
Of course that’s not a completely realistic scenario either, but it’s more likely than the first one.
What if he’d worried about a little bit of interest?
If Joe Student HAD worried about that 6% interest, chances are he would have paid off his $10,000 loan early. Say, in less than 2 years by sending $500 per month to it instead of just making minimum payments for 20 years.
Maybe he’d have thought “hey, if I can live on so much less than I originally thought every month, maybe I should invest that now that I’m done paying off this loan”.
Even at an abysmal 3% rate of return each year, $500 invested every month amounts to about $142,759 after 18 years. Which is a whole lot more than the $8,565, $29,416, or even $46,610 from the other scenarios.
Consider both the ideal scenarios and the things you are actually doing with your money. Don’t just cruise along on a low interest rate, assuming it’s nothing to worry about. Interest IS worth worrying about, both on the paying and the earning ends.
(This article is part of the Student Loan Debt Movement, which is encouraging and inspiring people to take action on their student loans.)