Pay off student loan or save?

By glblguy

ask-the-m-networkThis article is part of the Ask the M-Network series. Leah submitted a question and asked:

I’m 28. I have 9% of my income going into a 401k, no credit card debt, a paid-off 9-year-old car, and 5 months expenses in savings (some of that earmarked for the next new-to-me car). I also have a student loan of $11K at 2.5% interest. I want to start aggressively paying down the student loan, but because of the low interest rate my boyfriend is urging me to put that money in savings instead to earn interest and act as a larger emergency/irregular expenses fund. Am I better off holding on to the cash, or getting rid of the debt?

Update: I received the following reply from Leah after posting this article:

I wanted to thank you and your colleagues and readers for your advice on my question regarding saving vs. paying off student loan debt. It was really helpful to get advice from people who share my financial values and who understand the psychological value of being debt-free! I’ve decided to split my efforts between saving towards my next car and aggressively paying down the student loan.

I also really wanted to express my gratitude for the change in perspective this experience has offered me. The changes that have the most effect on our lives are not events, but changes in perspective. For the last 4 years I’ve felt like I’m really struggling to accomplish my financial goals without getting very far. Putting together a summary of my financial position and hearing all of your opinions on it – I finally feel like I’m succeeding. It’s time to feel the power of my accomplishments.

Thank you!!
Leah

Patrick from Cash Money Life

Several months ago when banks were paying 3% interest or more, I might have agreed with your boyfriend. But right now you have a very solid emergency fund and savings accounts aren’t paying very high interest. You would probably need to invest in CD’s to earn a 3% interest rate (if you can find those rates). The problem with CDs is that your money is tied up longer and you won’t have quick access to it. Based on your situation, I would probably repay the loans as quickly as possible, and for two reasons:

Repaying the debt makes sense financially. Since the interest in your emergency fund is paying less than the interest on your student loans, repaying those loans becomes a more attractive option.

Repaying the debt makes sense psychologically. Getting out from under the weight of debt is a huge psychological boost. It truly is like a weight being lifted off your back. Eliminating debt is one of the main principles Dave Ramsey teaches in his Financial Peace University. He believes you shouldn’t take on any unnecessary debt, and that you should work to eliminate any debt you have. You are in a financial position to eliminate the last remaining debt you have, which will free up additional money for other uses.

Overall, your financial position is moving in the right direction and I wish you the best.

Plonkee from Plonkee Money

If you can find a savings account that pays more than 2.5% interest then you might be better off financiallly by saving the money. On the other hand, you might benefit from a slightly larger emergency fund / savings as at the moment it’s taking people typically several months to find a new job when they’ve been laid off. Added to which, it’s not clear when your car is going to bite the dust.

Failing all those scenarios, paying off the loan is a better use of the money than just dumping it in a low interest savings account where the money has no particular purpose. Personally, I choose to invest extra money rather than pay off my student loan which is about the same size and interest rate as yours. But that brings up a whole raft of other questions about risk and asset allocation.

At the end of the day, regardless of what your boyfriend thinks you should do whatever sensible thing makes you most comfortable. You have already demonstrated that are perfectly capable of managing your own finances. You can make a good choice here too.

Pinyo from Moolanomy

I think you are doing great financially. The good news is that you are deciding between two good options, and you can’t go wrong choosing either one. If you want to pay down the student loan you should definitely do it. Dave Ramsey recommended paying off your debt first to million of people and they are doing just fine.

On a personal note, I agree with your boyfriend, because long-term investing will more than likely give you a better return on investment than paying down your 2.5% student loan. For example, you can increase your 401k contribution, or start contributing to Roth IRA. However, I wouldn’t simply put the money in a savings account right now due to the low interest rate. If you’re not going to put it in tax-advantaged vehicles like 401k or Roth IRA, you’re will be better off paying the student loan.

Paidtwice from I’ve Paid For This Twice Already”¦

Wow! It is like my life except you’re in a way better position! :)

I say pay off the debt. A savings account right now earns paltry interest. As long as savings accounts are earning so low, I would be aggressively getting rid of your financial obligation. You have a good sized emergency fund already.

When savings rates are high again if you still have the debt you could reconsider. Paying off debt rocks :)

Readers, what do you think? What would you recommend? Disagree with any of the replies?


17 Responses (including trackbacks) to “Pay off student loan or save?”

  1. Damian Says:

    Hi
    Its possible to get 3.5% in a fixed rate saver (with Halifax), even if you’re paying 40% tax, you still have 2.1% interest.
    So in the immediate situation, you save a little bit of money paying it off now, but lets assume it till take ~3+ years to pay off, by that point, you could again be earning 5%, and on a much larger sum of money

    Its also better to put more of the money into savings if you may been a loan in the forseeable future, as you won’t be able to get one for less then 2.5% interest (or 0.4% if you use halifax)

  2. DDFD at DivorcedDadFrugalDad.com Says:

    I’m with the boyfriend on this. When you are at one year’s worth of emergency fund– then start crushing the student loans.

    If it makes you feel better round up the student loan payments for now (e.g., $87/month– round up to $100/month).

    This young lady is in a very enviable position!

  3. South Texas Says:

    I don’t agree or disagree, but nobody mentioned that you can usually deduct student loan interest from your taxes.

    I would suggest that she add more to her 401k, she is only at 9%.

    Personally, the emotional benefits from being debt-free would outweigh any savings.

  4. HisHersMoney Says:

    I would recommend setting up a separate savings account to replace your 9 year old car that way you won’t have to take it out of your emergency fund when it comes time to replace it. Your student loan interest is deductible but your car loan interest isn’t if you have to take a loan.

  5. Baker @ ManVsDebt Says:

    Knock the socks off that debt! She’ll have no debt payments or obligations in the whole wide world. With that kind of freedom (actual and psychological), I’d be interested to she what she can do!

  6. TonyB Says:

    Pay off the loan. Even if you could find something that earns you 2% over your loan interest rate (good luck with that, not going to be easy to find something liquid and decent interest rate) your only going to make like $200 a year (that’s assuming you put the full 11k into savings). To me it is worth $200 to be debt free, plus once you have it paid off you’ll have that monthly payment to snowball into a savings plan.

  7. James Says:

    It’s amazing to hear of other people who have taken on-board and implemented great financial advise, and can have such an un-life threatening decision to make. You go girl!!!

    The answer I believe is a no brainer.

    The emergency fund is at a good size, enough to cope with unexpected emergencies.

    Pay off the student loan, and even if you don’t pay any money into your emergency fund it automatically becomes able to cope with longer problems, because your minimum monthly expenditure goes down.

    Once your monthly minimum goes down, it will be easier to increase the emergency fund after the car depletes it, and then take it up to a couple of years of cover, if you are that way inclined.

  8. Gina Says:

    I was in the exact same place 15 yrs ago. I chose your boyfriend’s path. It did not turn out well. Life will happen and things will get in the way.

    If I could go back and do it over, I would pay off the debt as soon as possible so I’m going with what “Baker @ Manvsdebt” said. The “freedom feeling” is invigorating! You will feel like there is NOTHING you cannot do. And you can then put the same amt you were paying on the debt into your savings/NTM car fund.

    GREAT JOB on managing your money so well!

  9. emma Says:

    Why not do a little of both? I would start with the goal of paying off the loan, knowing that if you had an expense you need to save for beyond your emergency fund (a car, a pending trip, etc) you could divert the extra money to that expense for 6 months or so and pay the minimum on your student loan for that time, then resume knocking out the loan full force.

  10. brett Says:

    your situation sounds identical to my own and i found this thread by trying to make the same decision myself. i think the some of it is the “financial” difference (likely under $500) is so nominal compared to the personal reward of (a) being debt free, or (b)making some sound investments at what one would hope is a pretty good time to buy long term roth funds.

    one important point that wasn’t mentioned, future debt. I imagine a frugal and financially savvy individual like yourself is interested in how far housing prices have fallen in the past couple years. Having 11,000 extra available for a downpayment will make you both a much more attractive borrower and put you in a position to negotiate the best mortgage possible. In short, while you may not be able to find 5% CDs like we could a few years ago, washing out the interest with a 2.0% savings account (they’re out there) and you basically have an interest free, no-hassle loan with options for deferrment .

    Not to mention the fact that you’re basically beating the interest rate with inflation alone (a cost of living adjustment at work, for example)

    anyway, those are my two cents and the bigger picture argument…how much you’re going to make doing one or the other is very little.

    this helped too, i think i’ve figured out what i want to do now

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