Should I Pay Off My Student Loans? What To Consider

It's estimated that nearly 120 million student loan accounts are currently in forbearance, which means that payments and interest are currently paused. That number has doubled since 2019, which makes sense given that payments and interest on federal student loans are currently paused. Many people’s finances have been severely impacted by COVID-19, and they’re taking advantage of these paused payments to use the money towards basic living expenses.

While the payments and interest on your student loans may be currently suspended, you’re still allowed to make principal-only payments on your student loan. If you can pay even a little towards your principal, you’ll end up paying less in total interest once the loan suspension is extended, and you'll pay off your student loans quicker. There are pros and cons to paying off your student loans early, and in this article we'll look at some of the factors you should consider.

The office of Federal Student Aid first began suspending loan payments and waiving interest on federal student loans in March 2020. The Coronavirus Aid, Relief and Economic Security Act (CARES Act) was signed into law on March 27, 2020 which extended the student loan relief measures until September 30, 2020.

Since then, the student loan forbearance has been extended multiple times. One of President Joe Biden’s first moves after his inauguration was to request the Department of Education extend student loan relief through September 30, 2021. In March 2021, these emergency relief measures were expanded to federal student loans made through the Federal Family Education Loan (FFEL) Program that are in default.

It's important to note that currently, this student loan interest waiver only applies to federally backed student loans. If your student loans are privately held, then you’ll need to contact your lender to see if they’re offering any programs. You may also consider refinancing your student loans if you’re in this situation.

If you reallocated the money you were using to pay your student loans to meet your basic needs during the pandemic, you should continue to use this time to get back on your feet, financially speaking. But if you can continue making payments, you can decide whether to continue making payments on your principal or to use that money in other ways while payments are paused.

If you have the financial ability to continue making payments on your student loan debt, there are a few options to consider.

Option A: Continue Regular Payments

One option is to continue making regular payments on your loan if you have the financial ability and flexibility to do so. Since the accumulation of interest is paused right now, 100% of your payment will go directly to pay off your loan balances. That means that effectively you are making payments with a 0% interest rate. The major advantage to this option of paying off your student loans is that when interest begins accruing again, your principal will be much lower, and so the amount of interest that you're charged will also be lower.

One disadvantage to continuing your regular student loan payments is that you might have better uses of that money. While you should make sure that you don't just use the extra money for frivolous expenses, you may be able to put that money in other investments or to make smart financial moves like starting an emergency fund. Keep in mind that because of the CARES Act, you can get your payments refunded if you need to, which makes this a lower risk option.

The ideal candidate for continuing regular payments would be someone that has a higher-than-average debt balance and a healthy income that covers more than just their basic needs.

Option B: Pause Payments Altogether

If your financial situation has been severely affected by the pandemic, it may make sense to pause your payments completely. If the monthly payment you were previously making on your student loan is now being used to meet basic living needs, then it makes sense to continue to pause your payments. You can use this time to get back on your feet and gain control of your overall financial situation.

If you're in a stable financial situation, you want to be careful about choosing to pause your payments. You may be tempted to take that money and spend it elsewhere. It should go without saying that you shouldn’t take that money and use it for frivolous expenses or to increase your standard of living. If you do, you'll be in a tough situation when the pause is lifted, and you’ll have to find a couple of hundred dollars extra in your budget each month.

You also want to be careful about investing that extra money. It might make sense to put those extra payments into a high-yield savings account, Certificate of Deposit (CD) or other liquid investment. That could help you start an emergency fund while still allowing easy access to your money if you need it. Be cautious about investing in the stock market, cryptocurrency, real estate or other investment that has more risk and/or is harder to get your money back out.

Option C: Make Extra Payments

Another option is to prioritize paying off student loans during this time. One pro of making extra payments is that you’ll lower your overall debt-to-income ratio.

Calculating how much interest you'll save by earning extra payments can help you make the right choice for your unique financial situation. There’s peace of mind in eliminating any kind of debt, and that may mean making extra payments is the right choice for you, even if it's not completely maximizing your finances.

Here are a few things you might want to consider before paying off student loans early.

Establish An Emergency Fund

If you don't already have an emergency fund, you could pause your student loan payments and redirect them into an emergency fund. This helps in two different ways – first, having an emergency fund can help protect you against unexpected expenses. And second, it keeps you in the habit of not spending that monthly amount. That way, when your regularly scheduled payments return, it won't be as much of a shock to your budget.

Pay Off Higher-Interest Debt

You might want to consider paying off higher interest debt, such as credit card debt, before paying off student loans. Whether to pay off student loans or credit cards is a decision that will depend on your specific situation. Remember, right now, you won't accrue any interest by not paying your student loans. If you are paying 18-24% interest or more on outstanding credit card debt, it might make sense to redirect money to paying off that higher-interest debt.

If you have several higher-interest debts, there are a couple of different ways you can choose to pay them off. Some people prefer the debt snowball method, where you make payments starting with the debt with the smallest balance. Others suggest the debt avalanche method, where you pay your debt with the highest interest rate first. The exact specifics of how you pay down your debt are not as important. Just find a strategy that works for you and stick with it.

Max Out Your 401(k)

Another thing to consider is contributing to your 401(k) to help save for retirement. It's important to consider your overall return on investment (ROI) when deciding if this makes sense for you. Return on investment is roughly calculated as the amount you earn divided by the money you’ve invested. For example, if you earn $600 after investing $10,000, then you have a 6% return on investment.

If you’re in a comfortable financial situation, you might consider maxing out your 401(k) or otherwise investing for retirement. You'll want to be careful with that money, because investing in the stock market is riskier than just putting your money in a savings account. While the long-term direction of the stock market is up, there’s a lot of short-term volatility. You don't want to invest any money in the stock market that you might need in the short term.

Invest In Assets

Depending on your financial situation, you might consider using the money to invest in other assets. This might include an IRA, real estate, a business or any other type of asset. Before you use that money to invest in any of those types of assets, make sure that you are in a stable financial situation and will have the money in place to resume making your payments when they resume.

These are some of the most common questions that we see regarding whether you should pay off your student loans.

Does Paying Off Student Loans Help My Credit?

When you pay off your student loan balance, it’s not likely to have a major impact on your credit. When you are paying on your student loans, they show up on your credit report as an installment loan, and making on-time payments has a positive effect on your credit profile. One other way that paying off a student loan can affect your credit is in your credit mix.

Your credit score considers the number of and type of loans you have. Student loans are considered installment loans, and if it’s your only installment loan, your credit may temporarily dip when you pay off your loan completely. Any such impact is likely to be temporary and relatively small compared to all the other factors that make up your credit score.

Is There A Penalty For Paying Off Student Loans Early?

If you’re wondering if there is a penalty for paying off student loans early, you’ll be pleased to know that there’s no prepayment penalty. This applies to both private student loans as well as federal student loans. While there is no penalty for paying off student loans early, there’s an opportunity cost to using money to pay off low-interest student loans instead of using that money for other investments. Consider all the factors before deciding to pay off student loans early.

Does Paying Off Student Loans Affect My Taxes?

While the principal balance of your student loans is not tax-deductible, the interest you pay on student loans may be tax-deductible. Depending on your tax situation, you may be able to deduct up to $2,500 of student loan interest. Paying off your student loans will mean that you’ll no longer have any student loan interest to deduct, so your taxable income may increase slightly. Still, it will almost always be a better idea to have 100% of those loan payments in your pocket instead of being able to deduct only 20-30% of them.

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Because short squeezes are risky one of the ways you can reduce your exposure is to continue making smart investments in other areas. Lots of investors don’t have a ton of experience, so before undertaking any investing strategy, it’s never a bad idea to speak with a financial advisor.

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It’s important to note however that this is certainly a risky investing strategy. It’s not something the normal investor should go into blindly. Be aware of your tolerance for risk. Make sure you know what you’re getting into and don’t hesitate to talk to someone.

The current pause on student loan payments offers an interesting opportunity for some people. If you’re otherwise in a stable financial situation, you might be wondering what you should do with the money that you were previously using to make your monthly student loan payment. You might consider pausing your student loan payments, continuing to make them or even making extra payments.

There are pros and cons to each of the different options, and the best choice will depend on your unique financial situation. Look at all the different options, calculate how much interest you'll save if you continue making payments and decide what's best for you. For more information, read more about student loan forgiveness programs.