Note: This article applies to federal student loans. Different advice applies if you have taken out a private student loan, mortgage, car loan, or payday loan.
Compound interest has garnered a reputation for being a force for good if you’re saving, but a force for doom if you’re taking out a loan. In broad strokes, this is true, but we should be careful before we get swept away in the terror and become obsessed with ensuring loan interest does not accrue.
If Your Only Income is a Student Loan, Return the Extra Money Instead of Paying Interest
I have met people who are aware of the good and evil powers of compound interest. However, in their effort to ward off the evils of compound interest, they pay off the interest that accrues each period. As a result they are actually paying more money than they have to. What do I mean? Let’s illustrate with a simple example:
Option 1: Paying Interest Off
Using this option, you use loan money left over to pay off the interest that has accrued.
|Initial Loan At 5% Interest||$10,000|
|Interest Accrued (+)||$500|
|Interest Paid (-)||$500|
Option 2: Reduce Loan Through a Loan Refund
Using this option, instead of paying off interest with extra loan money, you return the money and get a refund on your loan (interest does not accrue on the refunded amount). This only applies to federal loans and can only be done within 120 days of receiving the money, so set a calendar reminder 3-4 months after receiving your check so you remember to see if you can return any money.
|Refunded Amount (-)||$500|
|New Loan Amount||$9,500|
|Interest Accrued (+)||$475|
|Savings Over Option 1||$25|
In the context of total student loan debt, this is not likely to make the difference between financial stability and bankruptcy, but it is an improvement. Furthermore, it is painless. If you’re itching to pay off your loan as soon as possible, just tell your lender that you are sending the money back for a refund instead of having them use it to pay off your loan. You can get peace of mind knowing that you’re saving more money than you would if you paid off the interest.
The fastest way to reduce student debt is to reduce the principal taken out by returning any extra money to your lender.
What about Taxes?
First, this only matters if you file taxes as an independent. If you parents still claim you as a dependent, then this does not apply to you. Of course, your parents can claim the interest deduction on their taxes. If that’s the case, continue reading.
You can deduct interest paid on loans from your taxes, but this only applies if you choose to itemize your deductions and it depends upon your adjusted gross income. Overall, if you are single making less than $80,000 (or $160,000 if married) and you itemize your deductions, then it would be in your interest to actually pay the interest and deduct it from your taxes.
For the sake of not getting into the minutiae of tax deductions, consult with your accountant or tax software to see if you should itemize your deductions. If you do, then pay the interest.