college

Pay off student loan or invest money?

Don TaylorQuestionDear Dr. Don,
I would appreciate getting some advice on what option is best in repaying my student loan. At this point, the principal I owe on my Sallie Mae unsubsidized Stafford student loan is $9,500. The interest rate on it is currently 2.47 percent, and the monthly minimum due is around $115.

I am no longer a student and am on a standard repayment schedule. So, if I understand correctly, I am no longer eligible for the tax breaks for my next tax return, either.

I wonder how to calculate whether I would be best off simply outright paying off that $9,500 today and saving myself the interest I would accrue with remaining monthly payments, or should I invest the $9,500 I was going to use for repayment (say, put it into laddered certificates of deposit, etc.) instead? In other words, I wonder whether I am better off paying off my student loan today or investing that amount elsewhere for greater comparative return.

Thank you kindly!
-- Rita

AnswerDear Rita,
The student loan interest deduction doesn't go away when you graduate. There are some income limitations, and private loans may require completed Form W-9S, Request for Student's or Borrower's Taxpayer Identification Number and Certification, or similar statement to obtain the borrower's name, address and taxpayer identification number. The form also may be used by the borrower to certify that the student loan was incurred solely to pay for qualified education expenses. You should review the section on student loan interest deduction in Internal Revue Service Publication 970, Tax Benefits for Education, to determine deductibility. Consult with a tax professional if you can't determine whether you qualify for the deduction on your own.

My rule of thumb is you prepay the loan if the effective, after-tax rate on the student loan is higher than the expected, after-tax rate of return on your investments. The prepayment decision presumes that you have adequate emergency funds and you're not spending down that reserve to pay off the loan. If the choice is between contributing to your employer's 401(k) plan up to the limit of the company's matching contribution program, you'd choose retirement savings over loan prepayments.

The more conservatively you invest, the more likely it is that it makes sense to prepay the loan. A laddered CD portfolio using the highest yields from Bankrate's CD investment tool, with rates in late June shown in the table below, is likely to give you an after-tax return below the effective rate on your student loan -- even if the student loan interest is tax-deductible.

Laddered CD portfolio
CDAPY
1-year CD1.30%
2-year CD1.55%
3-year CD1.86%
5-year CD2.49%

You can estimate the after-tax return on your CDs by multiplying the yield by one minus your marginal tax rate, or (i %) x (1-t %). Bankrate's tax bracket calculator will help you find your average and marginal tax rates.

If your student loan interest does qualify for the interest deduction, you're reducing federal income taxes paid by the amount of the deduction times your marginal tax rate. You can find the effective rate on the student loan by multiplying the loan rate by one minus the tax rate. You can use Bankrate's mortgage tax deduction calculator to estimate the effective rate, just zero out the closing costs on the work sheet.

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