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Paying Off Your Good Debt Early—Savvy Strategy or Money Mistake?

by Emily Guy Birken

I hate debt.

It’s really that simple for me. I am uncomfortable with the idea of owing money, and so I generally avoid debt as much as possible, and I work to pay off any debt I have as quickly as possible. As of right now, the only debt I carry is my student loan and our mortgage, and I have been working my tail off trying to kill that student loan.

Pay off Debt or Save?

Should you pay off your student loans or invest?

But at the same time that I am sending the maximum that I can afford to my lender, I am also trying to beef up my retirement savings, since that has been on the back burner for several years. Debt feels more real to me than my retirement needs do, so I have been sending extra payments to my student loan while only giving the bare minimum (or less) to my retirement. The question is, have I been following a savvy money strategy or have I been shortchanging myself? I decided to find out.

How Much Will the Interest Cost You?

The first step in determining the best use of your money is to figure out exactly how much you will spend in interest with both your regular pay off schedule and with your accelerated schedule. Using the Crown Accelerated Debt Payoff Calculator, I discovered that it will take me 40 months to pay off the $13,169 remaining on my student loan if I send the minimum payment of $360 per month, and I will pay $1,022.10 in interest at my rate of 4.5%.

If I continue sending the $600 per month that I am currently allotting to my student loan payment, I will have the debt cleared in 23 months to the tune of $599.46 in interest. So far, so good. Apparently continuing with my quick-payoff plan will save me over $420 in interest and 17 months of payments.

How Much Will Your Money Otherwise Earn?

Of course, those calculations only tell half the story. I also need to determine just how much my retirement accounts will grow depending on how I choose to spend my money. Using the Savings/Investment Calculator on mycalculators.com, I found out the following:

If I pay off my loan in 23 months and send no extra money to my retirement accounts during that time, I will have $600 to send each month as soon as my loan is paid off. In that case, starting with $0 in my new retirement account and assuming that I earn a 5% return (which is a very conservative estimate) for the 17 months that I would otherwise still be paying my loan, I will come to the end of the 40 months with $9,931.24, $331.24 of which will be earned interest.

On the other hand, if I were to send the “excess” $240 to that same retirement account with a 5% return, I would end the 40-month period with $10,147.05, $787.05 of which will be earned interest.

At this point, it’s a little hard to tell what is the correct course of action. The amount that I earn in interest in each case is pretty close to the amount I’ll be paying in interest on the loan.

Other Factors

Again, that’s not the entire story. There are other factors at play:

Tax deductions: Up to $2500 worth of interest can be deducted per year. In either case, I will be paying much less than that amount in interest each year that I carry the loan, so I can take full advantage of the break.

Discipline: Some people need to have a specific agenda for every dollar or else it will be spent frivolously. I tend to be a “pay myself first” type—meaning that I send that $600 off each month and then figure out how to pay the rest of my bills. With just a slight tweak in my habits, I could easily start sending $240 off to my retirement account. For others, that nice round number of $600 might be too difficult to let go of.

Future income: As a freelancer, I’m not entirely sure how much I will make from one month to the next. If I knew for certain that my flush months were going to be the norm for the next several years, it might make more sense to pay off the loan early and count on a good income to help me make up the slack in retirement savings. Since I’m unsure of what to expect from month to month, it makes a more sense to send my lender the minimum, freeing up that extra money for retirement (or other needs, if necessary) until I can be sure of what my earnings will consistently be. After all, I don’t have to pay off my student loan early, as long as I am making payments.

Debt-to-Income ratio: This is part of how credit scores are determined, and carrying debt for longer than necessary can negatively affect your credit. Paying off that debt early can help to improve your score.

Emotion: No matter what the numbers may say, you may feel better paying off debt early. As long as you don’t use that as an excuse to neglect your savings or retirement, there is nothing wrong with doing what feels right.

My Choice

I have decided to reduce my student loan payment and send the rest to retirement. I have been ignoring my retirement needs for long enough that I feel it would be better for me psychologically to feel like I’m moving forward in that arena. And since the numbers put me slightly ahead by doing this, it was an easy decision.

Photo credit: the Italian voice


Published or updated December 21, 2011.
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{ 4 comments… read them below or add one }

1 krantcents

I always look at opportunity costs when it comes to investing or paying down debt. Admittedly, I only have a small mortgage that will be paid off by the time I retire in 5.5 years. I will have enough assets to support my retirement lifestle and will switch to spending vs. savings when I retire.

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2 Don @ MoneySmartGuides

One thing many people fail to realize is that the deduction of student loan interest is not a credit but a deduction. The difference is simple: a credit is a dollar for dollar reduction of your income tax. So, if the child credit is $100, you reduce your tax bill by that $100. But for deductions like student loan interest, you are only deducting the amount equal to your tax bracket. So, if you pay $100 in interest, you do not reduce your tax bill by $100. If you are in the 25% tax bracket, you get to deduct $25, reducing your tax bill by that $25.

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3 Emily Guy Birken

@Don, thanks for that clarification! I know it was something that confused me the first few years that I was doing my own taxes. The deduction for student loan interest is often cited as a reason to continue to make the minimum payments, but I don’t know that it’s nearly as helpful to your finances as that advice might have you believe. This is another situation where crunching the numbers is helpful in making a decision. I can’t vouch for this calculator, but this is one place online where you can determine what the interest deduction will do for your taxes:
http://chrisnolan.org/loandeduct.php

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4 MyMoneyDesign.com

Emily, I am with you. I HATE having debt! I’m really working hard this year towards paying off our car and reducing our mortgage payment.

I think you made the right move to shift more money towards your retirement account. The general rule of thumb is that if your debt is at a lower interest rate than what you can expect to earn from your investment, than go with the investment. If your student loan is 4.5%, than over the long run you should be doing better with your retirement fund (6 to 8%). I wrote an article a few months back where I compared paying off your mortgage versus putting the money away into an investment. After manually crunching the numbers in Excel, I came to the same conclusion as you that the investment (retirement) account would likely give you more money in the long run.

All things considered, however, this does not neglect the importance and sense of accomplishment that comes with paying off your debt. It think it is very important for people to consider all their options and make the best choices that fit THEIR plan.

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