Many college students graduate with student loan debt and carry that debt with them throughout adulthood. But that student loan debt may be hurting you more than you think.
You may be wondering if you should include your student loans in your debt payment plan or if you should worry about paying off your student loans early. If you're able, there are several good reasons to focus on paying off your student loans as soon as possible.
Your Debt-to-Income Ratio
One good reason to pay off your student loans is that it will lower your debt-to-income ratio. This measures how high your monthly debt payments are, compared to your monthly income. If you pay off your student loans, you will not only be free of those monthly payments, you'll also be able to reach other financial goals more easily.
A lower debt-to-income ratio is also important if you plan to apply for new credit, especially a mortgage. Most lenders will view a lower DTI ratio as a sign that you can afford to take on and responsibly repay new debt. You’ll usually need a DTI under 43% to qualify for a mortgage, for example, and even lower DTIs of 30% to 35% to truly show your debt is at a manageable level.
Paying off student loans will lower your DTI, which in turn makes you more likely to get approved for loans or credit, and qualify for better rates and offers in the future.
The Tax Break Isn't That Great
But you should realize that the student loan tax deduction has its limitations. The tax deduction is limited to $2,500 of student loan interest you pay. It also begins to phase out when your income reaches $70,000, and is eliminated at an adjusted gross income (AGI) of $85,000 (or $140,000 and $170,000, respectively, if you file a joint return) per year. Lastly, this deduction only indirectly lowers your tax bill by reducing your adjusted gross income.
This amount is nominal and you may pay much more in interest than you'd save via the tax break over the life of your loans. It's better to get rid of the student loans rather than hanging on to them for a tax break.
It's Costing You
Even if you take advantage of the student loan tax break, you should consider how much money you are losing each month due to both your student loan payment and interest.
Student loan interest is charged as a percentage of your current outstanding balance. As you make extra payments and lower your balance, the amount you’re charged will go down, as well. Paying off your student loans early also means you’ll pay less total interest compared to your loan costs if you follow your regular payment schedule.
Depending on the amount of student loan debt you have, your payment may take up a sizable chunk of your budget. If you pay off your student loans, you’’ll get rid of this payment and free up cash flow. Plus, you will be able to achieve other financial goals more quickly, such as saving up for a down payment on your first home, taking a trip, creating an investment portfolio, or starting your own business.
It's Virtually Inescapable
Many people who are overwhelmed by student loan debt hope that bankruptcy may offer a solution to their problem. However, if you declare bankruptcy, it's rare that your student loans will be pardoned through that process. Borrowers have to file a separate action to get student loans discharged in bankruptcy, and prove that repayment would impose “undue hardship.”
Beyond declaring bankruptcy, there are few ways you can get rid of your student loans. Federal student loans and some private student loans are discharged after the borrower’s death or total disability. Federal student loans also may be forgiven through qualifying for certain student loan forgiveness programs, such as Public Service Loan Forgiveness.
But the fact remains: For most borrowers, the best way out of student debt is to repay it.
Get Rid of Financial Worry
Student loans tend to be a great source of stress, hindering individuals from reaching financial stability. About one third of college graduates between the ages of 25 and 39 say they are living comfortably financially, compared with 51% of graduates in the same age group without outstanding student loans, according to recent data from the Pew Research Center.
If you want to reduce your financial stress, you should work on paying off your student loans. Even if your student loans are nearing the end of your debt payment plan, you can benefit by getting out of debt and reducing the amount you owe.
Creating a budget and a debt payment plan should be a priority when you graduate from college, as those steps can help you clear up your debt and make it possible for you to stop worrying about money.
Reasons to Not Pay Off Student Loans Early
Getting out of debt fast sounds great, but it's not always doable for everyone. Before you jump into a plan to decimate your student loan balance, take stock of your whole financial situation.
- If you don't have enough saved up: A healthy emergency fund can help you avoid going into debt when life gives you an expensive surprise. Prioritize building a savings reserve of three to six months’ worth of your crucial expenses before aggressively paying down student loan debt.
- If you have other debt: Student loans have relatively low interest rates, compared with other forms of credit like personal loans and credit cards. Be sure to compare interest rates when deciding what debt to tackle first—student loans probably won't be the first thing you want to get rid of if your main goal is to save money by getting out of debt.
IRS. "1040 and 1040-SR Instructions Tax Year 2020," Pages 91-92. Accessed Dec. 23, 2020.
Federal Student Aid. "Discharge in Bankruptcy." Accessed Dec. 23, 2020.
Federal Student Aid. "Student Loan Forgiveness." Accessed Dec. 23, 2020.
Pew Research Center. "5 Facts About Student Loans." Accessed Dec. 23, 2020.