We paid off my husband’s student loan from bschool a couple of days ago. It was a private loan from Citibank and interest rates had risen to 7%. Given the likelihood that the Fed will either halt or continue to raise rates in their upcoming meetings, and that conservatively speaking, 7% might be close to an average long-term investment return, I decided we were probably better off paying off the loan.
I’ve seen several articles and posts discussing the benefit of paying off a mortgage early, especially given rising interest rates. Student loans are no different: even if you can’t pay off an entire loan, paying more and having that applied toward the principal might help in the long run.
Here are some things to do and consider when it comes to student loans:
- Don’t let yourself become a zombie through automatic payments: E-statements and setting up automatic payments from an account can be efficient, but unless you get in the habit of regularly checking your statements each month, you might inadvertently overlook rising rates. We were guilty of this negligence and didn’t realize the 7% had creeped up on us until a friend in the same boat happened to mention it last week. (Thanks Ben!)
- Remember, the IRS allows a student loan interest deduction, subject to certain income limitations: Under current law, you might be able to deduct your interest payments on a student loan, up to $2500 worth in 2005, on your 1040 tax return (under an adjustment to income). However, you won’t be able to deduct the full amount once your modified adjusted gross income (MAGI) exceeds $50K (for singles) or $105K (on a joint return). If your MAGI exceeds $65K (singles) or $135K (joint), then you’re completely out of luck. (All figures for 2005.)
Compare your expected investment returns with the rate on the student loan: If you believe you’ll be able to get a better return on your money than the current interest rate on your student loan, you might be better off not paying off the loan, at least in its entirety. This is known as opportunity cost, and as an example, if your student loan stands at 4%, and you think you can get 7% in the long run on your investments, then you’re probably better off leveraging the 4% to make the extra 3% instead of paying it off. A bit simplistic and theoretical, but there it is. (My current understanding is that federal rates are still lower than 7%.)
- Consolidating loans: Unfortunately, I must leave it to someone else to write about this option. As a non-US resident when he applied for the loan, like all foreign students in our class, my husband only had access to the only private Citibank loan being offered to them (which, interestingly enough, was guaranteed by the school). Consolidation of several loans might be an option, but I can’t speak to any pitfalls or benefits of doing so. Sorry!
By the way, even if you don’t receive a form 1098-E from the lender stating your total student loan interest payments for that year, you can probably still take the student loan deduction on your tax return. We ran into that exact situation in 2004, and after calling the IRS to check, we received a letter from them confirming that we could take the deduction. I asked Citibank for a letter summarizing our payments and simply attached a copy of it to our return.