Is It a Good Idea to Overpay Your Student Loans?
July 8, 2016 | Your Finances
If you’re like most Americans, you probably have hefty student loan debt that weighs heavily on your mind.
In fact, according to a 2015 NerdWallet study, the average U.S. household carried $48,172 in student loan debt that year.
But instead of throwing all your extra money toward chipping away at that amount faster, you may want to take a hard look at your current financial picture and rethink your strategy. Should paying off student loan debt really top your priority list?
For starters, whether you’re tackling federal or private loans plays into the equation, says Matt Shapiro, a Certified Financial Planner™ with LearnVest Planning Services. That’s because private student loans typically have higher interest rates than federal loans, and federal loans also tend to have more flexible repayment options—factors that can play into how you decide to manage your debt.
Still, there are some basic goals you may want to set your sights on before fast-tracking any plans to accelerate paying down your student loans. See what financial bases you should try to have covered first, below.
Build Up Your Emergency Fund
If you’re fired up about getting out of education debt, here’s an important question to ask yourself first: How’s your emergency fund looking? For folks with less than one month of take-home pay saved, consider building that up before anything else.
“If all your other goals are met and you want to pay off your student loans, by all means, pay off those loans,” Shapiro says. “But I wouldn’t prioritize federal student loans over an emergency fund.” After all, if you hit hard times, you can’t exactly call up your student loan provider and ask for some of your money back to cover a pop-up emergency expense.
This is why Shapiro advises going a step further and building a fully stocked emergency fund before speeding up loan repayment. For those with federal loans, he suggests aiming to have six months’ worth of take-home pay before putting extra toward your monthly payments. If you have private loans, your strategy may require closer examination, but Shapiro says, in many cases, the emergency fund still wins.
“Every now and then we come across a private student loan with a 12% interest rate, and so that can kind of tip the scales,” he says. “If it’s a 5% private student loan, I probably wouldn’t throw extra money at it [first].”
In other words, every case is different. But directing all your additional income toward student loans while your emergency fund sits empty isn’t a smart idea.
Get Your Credit Card Debt In Check
Credit card debt is notorious for being a killer where interest rates are concerned, with the average APR landing at about 17%. If you’re currently carrying balances on any cards, paying them down should probably be prioritized ahead of juicing up your student loan repayment.
“You don’t really want to accelerate paying off a student loan when you have a credit card that’s charging you two or three times as much interest or more,” Shapiro says. Exceptions include situations in which your interest rate is higher on the loan than on the credit cards, which tend to be rare, even with private student loans.
For the 2015–2016 academic year, the average interest rate on a federal student loan was roughly 4% to 7%. Private loans offer variable rates, but the industry averages are estimated to range between 9% to 12%.
The takeaway: First zero in on whatever debt has the highest interest rate, which in many cases translates as credit card.
Make Sure Your Retirement Savings Are On Track
For those with a stocked emergency fund who are free of credit card debt, student loans seem like the likeliest next rung on the payoff ladder. Before you make any moves though, consider your retirement fund. A recent GOBankingRates.com survey found that most Americans aren’t on track with retirement; a whopping one in three have nothing saved at all. With numbers like these, throwing extra income toward your nest egg might make more sense for the long haul.
“If your employer has a match, you should at least be taking advantage of that before you even think about accelerating any student loan [payoff],” says Shapiro, adding that your loan’s interest rates also factor into this decision.
That’s because, hypothetically, a reasonable return to expect when you invest in the markets is between 6% to 8% over the long term. And if you’ve got a low interest rate on your student loan (say, 5%), it probably doesn’t make much sense to pay it off early. Why?
“[The student loan] is costing you less than what that extra money could otherwise earn if it was invested. Plus, there’s a slight tax benefit for student loan interest,” Shapiro says.
However, if the interest rate on your student loan is 8% or higher, prioritizing paying that off first before putting extra money into retirement may not be a bad idea. Paying 10% interest on a private loan could very well derail your long-term savings goals.
Generally speaking, though, Shapiro doesn’t recommend aggressively repaying your student loan unless you are on track with retirement. If you are, and you’ve also got a solid emergency fund and no credit card debt, good for you! It’s time to hit those student loans where it hurts.
To make the most of your efforts, begin by prioritizing any private loans first, followed by federal loans with the highest interest rates. From there, rejigger your budget to allow for increased payments—without sacrificing those important priorities we mentioned above.
LearnVest, Inc. is owned by NM Planning, LLC, a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, Wisconsin.