When to Worry About Interest

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
Total Amount $10,500
Interest Paid (-) $500
Loan Remaining $10,000

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.

Initial Loan $10,000
Refunded Amount (-) $500
New Loan Amount $9,500
Interest Accrued (+) $475
Loan Remaining $9,975
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.

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2 thoughts on “When to Worry About Interest

  1. I think this might be specific to certain kinds of federal loans. I don’t remember having the option of refunding money on mine, and interest also accrued daily after the grace period. The other thing is that I can’t think of a situation where the loan is in excess of what one spends, so how probable is it that you would have money to refund? Could you instead use the extra money to invest and maybe pay off the loan faster?

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    1. Generally, you take out loans each semester or each year. As a result, there are many instances where you may not spend as much as you budgeted for, such as when textbooks are cheaper than you had anticipated.

      As for investing and paying off the loan faster, I would not recommend trying to do that since the market can go up and down over a few months. It would be safer to either put it in a savings account or just return the money to the loan servicer.

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