Why You Shouldn't Pay off Student Loans Early (...Well Not Necessarily)

If you’re like me, you probably graduated from college with a decent amount of student loan debt, and now you’re slowly but surely paying it all off. While you are worried about paying it off, you have a stable income so making your monthly payments is very manageable. You might even be making (or considering making) extra payments to payoff your loans early, so you can be done with them ASAP. While doing so, you might be putting off investing for retirement (or not investing as much as you could) since your leftover income goes towards your extra loan payments. You’re probably wondering, “is this the best strategy, or should I be doing something different?” In this post, I want to talk about interesting concepts I think anyone with student loans (or any fixed-rate loan) must understand to answer this and other financial questions for themselves.

The first thing I want to discuss is the concept of opportunity cost. Opportunity cost is “the loss of potential gain from other alternatives when one alternative is chosen.”^[1] In other words, it’s the cost of not pursuing some Option A as a result of choosing to pursue some other Option B. Opportunity cost is an important concept to understand within the context of early loan repayment because the extra payments we make carry an opportunity cost with them. The opportunity cost in this case is that we can’t invest the extra funds we’re using to pay off our loans early and earn interest on them.

Your next question is probably, “how can I understand the opportunity cost of paying off my student loans early and decide if it still makes sense to do so?” To figure that out, we first need to introduce the concept of rate of return and understand the rate of return of paying off our student loans early. Paying off our student loans early is an investment after all. The rate of return of any investment “is the net gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s initial cost.”^[2] For example, let’s say we have a student loan with a fixed annual interest rate of 5%. Since it has an annual interest rate of 5% every year for the life of the loan, we can say that any extra payment on the principal amount earns us a rate of return of 5% annually. This is because each extra payment we make reduces the amount of interest we owe over the life of the loan.

To figure out the opportunity cost of our decision, we need to know what our other option is. If we decide not to pay off our student loans early, what else will we do with the extra cash? This could be different for everyone, but for the purpose of this post, let’s assume our other option is to invest our extra cash in a low-cost S&P500 index fund or ETF. The rate of return for pursuing this other option will then become our opportunity cost. Historically, the S&P500 has had an average annual rate of return of ~8%.^[3] By using our extra cash to pay off our loans, we are no longer able to invest in the stock market and earn that 8% return. This means the opportunity cost of us paying off our student loans early instead of investing in the S&P500 is 8%. When viewed through that lens, paying off our loans early doesn’t look like the best decision. Conversely, if we decide to invest in the S&P500 instead of paying off our student loans early, our opportunity cost of investing in the S&P500 is 5%, which is the annual interest rate of our loan.^[4] That’s a decision we would be happy with, so decide to continue making the minimum monthly payments on our student loans and invest our extra cash in the S&P500.

Knowing whether or not to pay off student loans early is a financial decision many of us face early on as adults, and you should now be better armed to make the decision for yourself. Framing investment options like above and comparing them by opportunity cost and rates of return is extremely useful when trying to decide which to choose and can help with any investment decision. Of course, maybe the peace of mind you achieve from paying off your loans and being done with them once and for all factors into your decision as well. That’s perfectly fine to include in your decision making. My goal with this post was simply to arm you with two important tools (opportunity cost and rates of return) for future financial decision making.

[1] Opportunity Cost

[2] Rate of Return – RoR

[3] What is the average annual return for the S&P 500?

[4] Comparing investments by their rates of return directly is possible because both rates are expressed in annual terms. When comparing rates of return, always make sure they are expressed in the same basis.