Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Student loan repayments

Dear Dr. Don,
I have $75,000 in student loans (at 8 percent interest) from undergraduate and medical school studies. My grace period ends next month, and then I will begin to pay these loans using an income-sensitive government repayment program. My grandfather has invested money for me, and now is giving me a gift of $8,000 to use for my education loans. Is it better to pay off the loans immediately with that money, or to invest it at a higher interest rate and pay later?
Aimee Analyze

Dear Aimee,
It sounds like your loans are on the income contingent repayment plan. With this plan, the monthly payments are based on your income and the total amount of Direct Loans borrowed. As your income rises or falls each year, the monthly payments will be adjusted accordingly. You have up to 25 years to repay, but any unpaid amount remaining after 25 years will be discharged, with taxes due on the amount discharged.

If you haven't already done so, you should consider consolidating your student loans. Consolidating will simplify the repayment process by having just one monthly payment, and may reduce your monthly payments.

The Federal Direct Consolidated Loans Information Center will help you decide if consolidation is right for you. That site's Interactive Loan Calculator can show you if there is a benefit to consolidating, even on the income contingent repayment plan. You can even apply online.

The interest rate on a consolidation loan is determined by taking the weighted average of the interest rates on your outstanding loans and rounding up to the nearest one-eighth of a percentage point but not more than the rate cap of 8.25 percent.

So the consolidated loan rate will vary by student. By applying for a consolidation loan while you're still in the grace period, you may benefit from a lower fixed interest rate on a direct consolidated loan. Consolidation may reduce the interest rate on your loan(s) to about 6 percent. This recent Bankrate story provides additional details on consolidating your student loan.

Decide whether you want to consolidate your loans before you decide whether to use your grandfather's gift to pay down the loans. If it was your grandfather's intent for you to use the money to pay down the loans, you should talk with him about your plans before investing the money.

From a financial perspective, if you expect to earn more from the investments on an after-tax basis than the loan(s) cost you on an after-tax basis, then you expect to be better off by investing the money.

Remember that expectations don't always pan out. The Dow Jones Industrial Average is down 6.83 percent year-to-date while the Standard & Poor's 500 index is down 12.28 percent. Saving 6 percent on $8,000 in loans looks a lot better than losing 7.5 percent in the stock market.

Over time the stock market should provide an average return, after taxes, higher than the after-tax cost of your student loans. (See this Bankrate article for more information on the deductibility of student loan interest.)

-- Posted: Dec. 6, 2001