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Student Loans: How to Pay Them Off and Build Wealth

By , November 15th, 2007 | 37 Comments »

By David John Marotta and Beth Anderson Nedelisky

The average college student graduates with almost $20,000 in student loans. While this is a daunting sum, it is still possible to build wealth even while paying off student debt. But earning the degree and paying for the degree require two different kinds of smarts. In fact, some students may be better off not taking their parents’ advice on how to get out of debt. Unlike most types of debt, student loans are usually best when paid as slowly as possible.

Almost all debt is bad debt. But, there are two important exceptions to this rule: home mortgages and student loans. Diligent savers can use these types of debt to their advantage.

Students often assume the best thing to do is to pay off student loans as quickly as possible. The sooner you pay off your loans, the sooner you can start building wealth, or so the thinking goes. But, given the opportunity, which answer should you choose: A) Make extra principle payments on your loan each month, or B) Pay the minimum amount due and save and invest the difference?

The real answer is: it depends. However as a rule of thumb, the lower the interest rate on your loans, the better off you’ll be just paying the minimum monthly payment and nothing more. Take the extra money you were going to pay on your loan and invest it instead.

The lower the rate of interest on your loan and the higher the average market return, the more it makes sense to invest your extra dollars instead of paying down on your loan. The difference between these two rates is known as the “spread.” If market rate of return is 11% and the interest on your student loan is 4%, then, the “spread” is 7% (11% minus 5%).

Let’s look at two examples. Jane and Joe each have $20,000 in student loans which are to be paid over 10 years at 4% interest. Joe pays his monthly payments of $202 plus $100 extra to retire his debt as quickly as possible. By paying making bigger payments, Joe is able to pay off his debt in just over 6 years. Now, with his debt out of the way, Joe invests the full $302 per month that he had been putting towards his debt. Ten years after graduating, Joe has paid off his school debt and his investments have grown to $16,728.

Jane decides to adopt a different loan repayment strategy. Instead of paying extra on her loans, Jane pays only the minimum amount of $202. She takes the extra $100 per month that she could have been paying toward her debt and invests it. She continues this simple plan for the full life of her loan. Because she makes no extra payments on her loan, she takes the full 10 years to pay off her loan. Now, ten years later, Jane’s loan is finally paid. However, her investments have grown to $21,700, beating Joe’s return by $4,972!

Jane has made more than Joe even though she only paid the minimum balance due on her loan. Instead of making extra payments as Joe did, she invested her money for a longer period of time. And even though Joe was able to retire his debt sooner than Jane, his big monthly investments were unable to catch up with Jane’s early saving. Jane was able to boost her savings by starting early and harnessing the power of compounding interest. In the investing world, we call this principle the ‘time-value’ of money.

However, this model is not ideal for everyone facing student loans. The smaller the spread between your loan interest rate and the average market return, the less appealing this strategy becomes.

But, there is one additional reason students should consider paying just the minimum monthly payment on student loans. Student loan interest, like home mortgage interest, is tax deductible. By allowing you a tax deduction of up to $2,500 for student loan interest, Uncle Sam is, in effect, helping to subsidize the cost of your loan. The faster you pay down principle, the faster you lose your tax deduction, which is one more reason that paying just the minimum may be the best option. And, with the savings from your tax deduction, you have more money to invest at higher rates of return.

In order to benefit from this loan repayment strategy, you must save and invest your money. If you don’t invest the extra money, you would have been better off putting your extra dollars toward the repayment of your loan. But before deciding on a loan repayment strategy that’s right for you, be sure to take care of the basics of first.

Learn about your loans: Many student loans allow for a 6-9 month grace period before loan repayment begins. During this time, your loans may be charged a lower rate of interest. Consider consolidating your loans and locking in your interest rate while your loans are at a lower rate. This may not only help keep the cost of borrowing lower, but it will mean you only have to write one check per month.

Establish an emergency fund: You should have enough money in your emergency fund to cover three months of expenses. This money should be used only in the case of emergencies, and not for those late-night runs to Taco Bell.

Pay off your credit card: It’s estimated that college graduates carry an average of $2,500 in credit card debt. Most credit cards have very high interest costs. Be sure that you are not one of them. You cannot build wealth while paying 19% interest on your credit card purchases. Do not begin investing until you have an emergency fund and have eliminated your credit card debt. If you do carry a balance consider transferring to another card. Discover has some pretty good offers.


Sign up for free money: If you have just started a new job, check to see what type of retirement benefits your company offers. Many companies will match your contributions dollar-for-dollar up to a certain percent of your pay. In other words, you get free money if you invest in the company retirement plan. Make every effort to contribute enough to get the full match. By doing so, you are, in essence, receiving a 100% return on your money. And, don’t assume you are too young to save for retirement. By saving now, and harnessing the power of compounding interest, you’ll have enough to retire long before most of your friends. Remember the time-value of money!

Contribute to a Roth IRA: Once you’ve built up an emergency fund, paid off your credit cards, and taken advantage of any free money available through your employer, make every effort to invest any remaining dollars in a Roth IRA. A Roth IRA is the ideal place to put those extra dollars you were otherwise going to apply to your student loan principle.

Building wealth takes time. By starting early, you’ll be sure to make the grade.

David John Marotta and Beth Anderson Nedelisky work at Marotta Asset Management, Inc. of Charlottesville which provides fee-only financial planning and asset management.

Image courtesy of mischiru

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  • Karen says:

    A couple of comments. One, student loan interest is only deductible up to a certain income level. You don’t have to itemize your taxes to take it, which is a big plus, but it phases out when you reach a certain income (about $60K if I remember correctly). This may not affect a lot of new graduates, but if you live in an expensive area of the country, you may hit that salary level sooner than you think.

    One advantage of student loans (at least, the government-provided ones that I had) is that you can suspend them if you lose your job, or under other “hardship” circumstances. You’ll still accrue interest, so it’s better to keep paying if you can, but it’s a safety net if you find yourself unemployed for a long period of time, or facing a temporary disability, etc.

  • Michael says:

    It’s true that you can apply for a hardship deferral on student loan payments.

    However one other point to mention is that student loan debt is NOT bankruptable…

    I think it’s better to pay them off as quickly as possible.

  • Traciatim says:

    I’m with Michael, it’s best to pay them off. I’m in Canada but we have similar rules around student loans. My two loans are at Prime+1 and Prime+2. Though the interest is deductible (and mortgage interest isn’t in Canada) I still think they need to be paid.

    I would also argue that most people aren’t disciplined enough to actually invest the difference. This same rule of thought is with mortgages too, but I think most people would ‘invest’ the difference in consumable goods and other ‘stuff’ they don’t need.

    The best option for the majority is get rid of all your debt, then start a pre-authed monthly investment that’s easy to forget about, then spend the money you make on top of that. It’s simple, it works, and it’s easy to setup.

  • db1974 says:

    Should we also consider how much Jane and Joe each paid in interest before their loans were paid off?

  • computerpunk says:

    I think db1974 is right in that we should consider the total amount paid by both parties instead of just focusing on the returns.

    Another point is that, we are assuming that the amount invested is actually generating returns. This… is something that is unpredictable. If you do something stupid , you might end up worse off also. So in a way , I guess it’s quite up to individual… Are you able to achieve the state where you’ll be better off than you will be if you paid off everything(i.e. your investment returns is more than what you paid).

  • Dr. D says:

    This is wise article because it’s a reminder that no single solution is right for everyone’s situation. You have to crunch the numbers based on your loans and income, and determine what gives you the best results.
    My honey has student debt to the tune of $90k. Half of those loans are private and at an 8% adjustable rate. You bet your beans we’re working to get those gone.
    But the Federal loans secured at 3% will be paid off over the full term, as it is smart to take any extra and put that away for the future. Just like with clothing, there is no “one size fits all” when it comes to financial decisions.

  • Free From Broke says:

    Great article! We just paid off my wife’s private student loan which was around 9% interest. She still has loans outstanding but they are closer to 3% so we’re concentrating more on saving and investing than paying those off.

  • Allie says:

    Great article! I really like that you take the time to stress that everyone has to consider their own situation. I am *extremely* fortunate to have low, fixed rates on my student loans, but I, too, will be paying them off early – this year, in fact (if all goes well). Within the next two years, I plan on taking a job that will pay significantly less than my current one in order to gain the knowledge and experience which will (hopefully) lead to a higher-paying career. Having a smaller “financial footprint” will allow me *much* more flexibility during that time. But mostly, I’m looking forward to having one less bill to worry about!

  • steve says:

    Its been a Looooooong time since there was an interest rate spread like the example cited. Always pay your future self first. That is savings and investments. Max your 401 and any pretax benefit. Follow it up by maxing IRA contributions. Then you may fall below the limit for writing off the interest. What ever is left is your income.

    I payed my student loans off today. I am in repayment on three kids as we speak. I take my own advice.

  • Nicbarb says:

    I have over $100,000 in student loans, 60% consolidated and 40% private loans. My private loans are at 7.5 and 6.25. With the current lower interest rates, I am considering applying for a five year, lower interest bank loan, to pay off the private loans. Any thoughts?

  • Kevin says:

    I think the only issue there is that the bank loan would likely have to be secured by some collateral, perhaps a lien on your home. This may not be the best thing for you.

    As for me, my wife and I combine for OVER $280,000 in student loan debt. Our combined monthly payment tops $1,500 per month. We can afford to carry it, but it’s like an anchor around our necks.

    I don’t know if it’s better to pay them down little by little, or just keep making the $1500 payments for the next 20 years.

  • John Svid says:

    Wow great site! Some really helpful information there.

  • Marcus says:

    I’m going to be 24. I pay only the minimum amount on my loan and have been since I have had it. I don’t plan on paying anymore than the minimum. Most people need to think longterm as opposed to the short-tern gratification paying off a bigger chunk of the loan. Mortgage Debt and Student Loan debt is GOOD debt. Paying off these GOOD debts only to keep your other BAD debt is financial suicide. You will bury yourself deeper. If you are inclined to pay off an extra 100 bucks a month and if you didn’t you would just waste the 100 bucks on junk or actually put it into a savings account then you are better off putting it toward your student loan. If you actually invest this 100 dollars then that is the better choice.

  • Zack says:

    My wifes studnet loan payment is $290 a month…less than $90 goes to principal…how can that possibly be a good thing…


    Ask how much you pay in interest by the time you pay it off…

  • Missy says:

    This artical is stupid. Who the hell has to money to pay these stupid loans??!!? A college degree is about the equivalent of a high school dipola these days…basically, the degree isn’t worth the paper that it is printed on. For someone who works hard, full time and struggles to pay just the minimum payment and only pays off $10 on their loans EVERY TWO YEARS…this plan is rediculous. Give me something I can really use.

  • Nancy says:

    I agree that the minimum payment plan is flawed because of the amount that interest adds to the loans. My loan is 27K and the amount I will pay after interest over the 20 yr course of my loan is 47K! I Have been paying for over a year and have yet to have even a single dollar go towards the principal.
    This year I plan on sending an extra $100 a month and as my salary goes up, so will the extra payment amount.
    The concept is interesting, but the omission in total amounts paid with interest makes it inaccurate.

  • Audrey says:

    I read your article on student loans and it was the best I’ve read. Maybe you can help me, I’m trying to locate a bank or a finance facility having low interest rates for paying off student loans. I’ve been checking in my area, Hercules, Ca and the interest rates are pretty high. I’m doing this for my niece and she presently owes $50,000 and is being charged 10% interest on a monthly basis and the $amount she is paying is about to wipe she and her husband out. Her husband is in the military and getting ready to go over sea’s and the combination of the two is really getting to her. Any subjestions will be appreaciated.

  • lisa says:

    Even though the math for total interest paid isn’t applicable to this situation (the total deficit for each individual is $302 per month, regardless of where it goes – loan payoff or investment), here are the numbers for the curious:

    Joe: $2,529.10
    Jane: $4,298.84

  • Patrick says:

    I how this article emphasizes that the decision to pay extra or save really depends on your situation. I think the heart of this issue is involves the concept of “Opportunity Cost”.

    I am sure I am oversimplifying and butchering the terminology, but here is an example: You can either keep $1000 in you checking account, or put it in a savings account with 5% APY. The “cost” of NOT placing that money in the savings account is $50 per year. This is the same as if your checking account charged a $50 annual fee. (i.e. making a decision that results in you NOT earning $50 is the SAME as losing $50).

    This might seem obvious but in practice this is not the way a lot of people think. I graduated with similar amounts of student loans as a few of my friends- we were fortunate enough to lock them in at < 3%. There are plenty of 100% guaranteed savings options that beat that %, some of which that don’t even restrict access to your money (like an online savings account). Despite all this some of my friends chose to pay off their loans early instead of saving at a higher rate. This decision cost them money overall- even though they will pay less interest on their student loans then if they saved. They basically paid a fee to pay off their loans early.

    BTW- notice I said 100% guaranteed options- understanding the risk associated with your decisions is extremely important.

  • Greg says:

    My wife has a student loan of $16700 at 4.125% interest. The monthly payments are $147 for the next 12 years. The interest will total more than $5000 if we take that method. We have decided to pay $500 a month on them which will reduce it to three years and save us $4000 in interest. We already have an emergency fund w/ 6 months and max out our Roth IRAs each year. Neither of us have a 401K or that would be a priority. If we just put the difference in an online savings account @ 1.7% interest that means we are still losing 2.45%. And tax deductible? Who cares, I’d rather not have to pay interest to begin with! While our money is earning less interest, it is less valuable so we might as well seize the opportunity to tear into the loan. If we were making more like 8% then this would be another story.

  • Tracy Shannon says:

    Joe paid off his loan sooner thus in the end paid less for the loan, while jane paid for more. I paid a total of 1500 last year. 750 went to the pricipal of the loan and 750 went to interest alone. I cant see how it is beneifical not to pay off the loan ASAP!

  • Pam Palmore says:

    I have been approved for a hardship deferment. I can afford to pay some on my loan. Should I request that my payment be applied to the principle or the interest?

  • Kris says:

    I started out with $220,000 in loans. There is light at the end of the tunnel! I paid extra toward my high-interest private loan when the (variable) rate was high, and now I pay the minimum as the rate is low again. I have finally gotten to where I’m paying mostly principal and very little interest!!!

    When the option exists, always pay down principal (to the one asking which to put money on while in deferrment) But that may not be allowed. The big thing to know is that the unpaid interest acrued during deferment likely capitalizes, meaning gets added to the principal.

    All the other comments are correct about the certainty of your investment vs interest expense saved.

    My biggest piece of advice is don’t take out new debt!!!

  • Vic says:

    Can this be right?

    =Joe over 10 years=
    Expense: $302/month * 72 months = $21,744
    Earnings: $16,728
    Balance: $5,016

    =Jane over 10 years=
    Expense: $202/month * 120 months = $24,240
    Earnings: $21,700
    Balance: $2,540

    So Joe ends up with almost twice as much money as Jane.

    It seems like this leads to the opposite conclusion of this blog post, doesn’t it? Aren’t Jane’s higher investment returns more than offset by the extra interest she pays on the loan in this case? Or am I missing something?

  • Tom says:

    11% return on investments requires some pretty smart investing these days.

    I’ve got a 3.5% loan, and still think it’s smarter to pay it off asap. On only 6,000 dollars loan left, I’m still paying about 20 dollars a month in interest…and I’ve been out of school for 6 years now. Tired of it.

  • Ryan says:

    Vic your fuzzy math is backward, you flipped the arithmetic. Joe had $21,744 in expenses and $16,728 in earnings for a net outflow of . Jane paid out $24,240 but earned $21,700 for a net outflow of . Yes, Jane had to pay more interest on the loan, while Joe saved some money on interest by paying back the loan quicker. But Jane still had twice as much b/c of the power of her compounding returns, which proves the author correct.

  • Vic says:

    Thanks for the reply, Ryan. There’s nothing fuzzy about the computation, it’s just incorrect. A more parsimonious explanation than yours: The balances are negative. QED.

  • Dale says:

    I believe it’s extremely important to not get Unsub loans since these loans begin to accumulate interest as soon as funds are disbursed. I’ve learned thru the process and inform teenagers heading to college to only accept the amount needed (avoid the UNSUB LOANS), accept only partial amounts enough for paying tuition and textbooks. I wouldn’t recommend bank loans since now every bank only offers variable % rates. I believe every situation is different. Every loan institution is different. Payments usually get applied to any outstanding interest first, then to the principal. I strongly believe paying it off sooner is better…good luck all.

  • Magdalene says:

    I absolutely agree with the author of this article. I have 100,000 in student loan debt. I am not a doctor or a lawyer. In fact I got my degree in liberal arts. I am not killing myself trying to pay more than the minimum on my student loan payments, which total about $1,100 a month. Here’s what I am doing:

    -My company matches 50 cents on the dollar so I am contributing the maximum to my 401K. It’s free money. Always take advantage of this.
    -I am contributing to a Roth IRA every month
    -And I am making sure that I get that tax deduction for having student loans
    -I am saving to purchase a condo in three years.
    -I sell stuff I have around the house to make a few extra bucks on ebay
    -I use to save on my grocery bill. This website is free and gives your great tips on how to use coupons to save. It has changed my life.

    I used to get so depressed at the amount of my student loan debt but it is not the end of the world. I have done my research online and know that there are other people out there in the same situation. My advice to recent college grads is to negotiate the salary for your first job. I got my degree in sociology. I was the first in my family to go to college and I really did not know what to study. Looking back, I wish I would have gotten a degree in business or marketing. But I have learned that if you market yourself right and get some experience, you can get any job you want. Believe me, I used to feel so alone and depressed but I have done my research. Reading other people’s experience and seeing what they are doing has really helped!

  • CJ says:

    whether it has been said in any of the comments posted so far or not, the solution is simple: if the interest rate on your loan is greater than your expected return on any investments you may make with the extra money, then put as much extra toward the loan as you can! it’s a guaranteed return on your money…finance 101: opportunity cost!

  • BD says:

    So how do we account for inflation?
    Let’s compare paying off a loan total of $27k today verses, let’s say $47k over the course of 20 years. You have to consider than 20 years from now currency will most likely have inflated… Can someone else more knowledgeable in economics make a comment?

  • Todd Kindred says:

    Hmm, first, you are investing in some very risky investments to return 11%. Highly unlikely. Second, isn’t interest earned by Jane taxed as earned income? While interest paid on student loans is tax deductible?

  • Rob says:

    I don’t want to beat a dead horse, but as stated above this issue depends on each persons financial situation. I have about 13k in loans (started with 19k) and graduated 3 years ago. My interest rate is 6.5%. I understand I may make 1.5% more (on average) investing, however the transaction costs would likely match the rate of return on my investment.

    I am of the believe that student debt is still debt. The upside is we get a little stipend from Uncle Sam for our interest paid, but the major downside is that while we have debt we are not using the best vehicle available: Time value of Money.

    Therefore if the spreads are marginal and the debt is lingering. Like me, let’s get rid of it ASAP and reap the rewards after. Plus its a good feeling to have when it’s all paid off.

  • Katie says:

    That 11% ROI will require lots of risk. You may just as easily end up with a -11% ROI.

    I graduated in 2008 with 73K in debt (abt 6K of that was capitalized interest). In February this year I realized I was putting away a lot of money into my savings acct, earning 0.3% interest, while I was paying 6.8% interest on some of my federal loans. Plus, I will be unable to claim any sort of tax credit this year. So, since then (without dipping into my 6mos emergency fund), I’ve taken my student loan debt from 61K down to 53K. And I’m hoping to pay off my $6700 loan at 5% by this time next year. The rest of my loans will most likely be waiting a bit longer. B/c between 1.75% and 2.5%, I’m not going to kill myself to pay those off now.


  • Geezeo Blog » Student Loans - What to do… says:

    […] This is a great blog! It talks about student loans and what to do after you graduate. The blog called “Student Loans: How to Pay Them Off and Build Wealth” explains that they two exceptions to bad debt are home mortgages and student loans. It gives you examples on the best time to pay off your loans depending on what your interest rates are, or whether you should put your money away and save. This blog will give you some great advice on what to do after graduation and when you’re in the real world…so check it out! […]

  • […] Saving Advice tells how to pay off your student loans and build your wealth. […]

  • 25 Financial Terms Students Should Know Before Taking Out a Loan - Best Colleges Online says:

    […] Principal: This is the base amount of the loan. Defaulting on a loan is so terrible because the lender will take what payments you are able to make and apply it first to interest and fees, and principal last. You have to pay off the principal to make progress toward paying off your loan. […]

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