Student Loan Strategies: Maximizing Net Worth

For today’s young professionals, student loans have grown to become a significant financial obstacle. A common question is if it makes sense to pay off these loans early.

First, before considering making additional payments, I’d counsel investors to:
1) have paid off any credit card balances;
2) establish an emergency fund of at least 6 months reserves, and 12 months if their income is unknown or employment is in any way tentative; and
3) save up for a house down payment, if home ownership is a goal.

Having the cash available to pay off a loan is terrific, but I caution people to not forgo their retirement savings in lieu of their student loans.  I know that for many recent graduates it seems appealing to get out from under those loans as quickly as possible, so they think they should wait on contributing to their 401(k) and put as much as possible towards the loans.  When you look at the effects of compounding, however, the money you invest in your 20’s and 30’s into your retirement accounts is much more valuable than the same dollars invested in your 40’s and 50’s.  Often times your net worth will be higher by starting to invest earlier and taking your time with the loan repayment.  And of course, you can test this projection with most financial planning software programs or a spreadsheet.

Another factor to consider on the decision to repay is the tax deduction.  For 2014, you can deduct up to $2,500 in student loan interest from your federal tax return.  This deduction is limited, however, based on your modified adjusted gross income (MAGI).

Single taxpayer: full deduction below $65,000 MAGI, phaseout $65,000 – $80,000
Married filing jointly: full deduction below $130,000 MAGI, phaseout $130,000 – $160,000

I would note that student loan rates are variable and have crept up in the past couple of years. Additionally, as your career progresses and income increases, many families lose their eligibility to take advantage of this tax deduction. I point this out because another important question is: Which is better to pre-pay, student loans or your home mortgage?  The mortgage interest deduction does not have an income limit and is not capped at $2,500.  Also, most mortgages are fixed, not variable.  That’s why I suggest most borrowers make extra payments towards student loans rather than their home mortgage.

For those who can receive the student loan interest tax deduction, it lowers your cost of borrowing, so I would consider the after-tax cost of borrowing when deciding if early loan repayment makes sense.  Most borrowers I counsel have multiple loans at various interest rates, so it is often best to send extra payments towards the student loan with the highest interest rate and make only the minimum payments on the other loans.  Over time, we will pay off the highest rate loan first.  Then that monthly payment can be applied towards other loans.  Additionally, paying off one loan first will reduce your total monthly minimum payments, which is highly valuable should you have any sort of temporary setback like a job loss.

The earlier you can make extra payments, the better.  If your interest rate is 5%, paying an extra $1,000 today will mean that you are saving $50 in interest in every year going forward.  Early principal payments will shorten the length of the loan more dramatically than extra payments made in future years.  If you scrimp a bit now and make extra payments, you will reduce your total interest payments over the life of the loan.

Be careful about consolidating loans. Most people consolidate to lower their monthly payment amount, but inadvertently add years to their loans and thousands in interest payments. Additionally, if you are consolidating Federal loans, such as Stafford Loans, into private loans, you will be giving up access to Federal loans benefits such as forbearance, income-based payments, or loan forgiveness. Before consolidating, make sure you are not going to lose any pre-paid interest if you are ahead on your payment schedule.

Many people think a financial plan deals only with the Asset side of your balance sheet, but some of the most important choices are about how to manage your Liabilities. Student loans are an investment in yourself, so make sure your subsequent cash flow decisions are helping to maximize your net worth in the long run.