Paying off a Student Loan
This calculator can be used to run through “what if” scenarios aimed at paying off a student loan ahead of schedule. The calculator needs a total of five inputs, including:
- The current monthly payment on the student loan
- The remaining balance, also known as the remaining principal, of the loan
- The annual rate of interest paid the lender on the outstanding balance of the loan
- The extra payment to be modeled as part of the loan payoff scenarios
- Finally, the calculator allows you to select whether the extra payment is a one-time payment or is an increase to the monthly payment
The calculator then provides the user with three sets of outputs, including:
- Given the monthly payment, annual interest rate, and the remaining principal of the student loan, the calculator provides the remaining number payments, the total interest paid, the total of all payments, and the month and year of the last payment
- The next set of data provides the same information and includes the impact of making an extra payment
- The final set of data provides the number of monthly payments saved, the total interest charges avoided, and the number of years and months saved
Does Paying off a Student Loan Make Sense?
While a college education can mean a higher paying job, it does so at a cost. According to statistics published by the US Department of Education, around 70% of college graduates have debt. Fortunately, these student loans are frequently offered at attractive interest rates and can be paid off over terms up to 30 years. For example, a student graduating with 60,000 in loans might have to pay around 300 per month for 30 years to repay the loan.
As the college graduate gains experience in the workplace, their ever-increasing value to employers should result in higher wages. So, while 300 per month may seem like a lot of money to a recent graduate, someone with ten years of experience making more money, might consider paying off their student loans or increasing their monthly payment to accelerate the payoff timeline. People that find themselves in this situation, may wonder to themselves – Does it make sense to pay off my student loan?
Of course, the answer to that question is a definitive – It depends. The answer really comes down to the concept of opportunity cost, which is a financial concept that goes something like this:
An investor’s opportunity cost is the potential gain they lose when they choose one investment over another.
You might be scratching your head thinking a loan isn’t an investment, but the money sitting idly in a bank account is an investment. If you choose to invest your money is a savings account earning close to zero percent interest instead of “investing” that money in a student loan at 4.250%, you are losing out on an opportunity to pay less interest on the loan. So, a simple rule of thumb might go something like this:
It makes sense to pay down a student loan if the interest rate on the loan is higher than what you would earn on the alternative investment.
Of course, even simple rules are made to be broken, and someone could argue we should really be looking at after-tax rates, but student loans normally aren’t tax deductible, so our simple rule of thumb is a good one.
Interpreting the Results of Our Calculator
Our calculator allows you to model two types of scenarios. If you happen to have a relatively large sum of money available to invest in your student loan, then set the Pay Frequency to One-Time. This allows you to understand the savings associated with making a lump sum payment. Alternatively, if the Pay Frequency is set to Monthly, then you can vary the Extra Payment input and see how it affects the number of payments and interest charges, which is really the money saved by paying off the loan.