Should You Pay Off Your Student Loans As Fast As Possible?

Before you touch your student loans, you need to build an emergency fund. An emergency fund is simply a cash reserve that you can access to pay for unexpected expenses. If you try to attack your student loans without having this cash reserve, you can end up in a bad spot financially.

For example, say that you have $25,000 worth of student loans, but have managed to save $5,000. You have heard that paying off debt as fast as possible is a good idea so you decide to throw your $5,000 at your student loans to reduce the balance.

A few months go by and your car breaks down. You find out it is going to cost $1,500 to repair. Since you no longer have a cash reserve, you may have to finance the repair by putting it on a credit card which will only drive you further into debt. This clearly moves you in the wrong direction financially.

At the very least, you want to have a starter emergency fund of $1,000. A fully funded emergency fund is typically 3 to 6 months worth of expenses, but it may be better to start with a small amount depending on other financial factors in your life such as paying off student loans.

Almost every single personal financial decision that you make boils down to resource allocation. Resource allocation is simply how you use the available funds that you have. The reality is that everyone is working with limited resources.

It does not matter if you make $60,000 a year or $600,000 a year. What matters is how you use your available dollars. With this concept in mind, you need to ask yourself if the best use of your dollars is to pay off your student loans as fast as possible?

In some cases, it may make sense to pay down your student loans as fast as possible. However, do not immediately jump to the conclusion that paying off your student loans as fast as possible is your best bet. Your money may be better utilized elsewhere.

We discussed resource allocation above. When you understand that you have limited resources, you can begin to make smarter financial decisions. The way that you decide how to allocate your dollars is by understanding opportunity cost.

Opportunity cost is an economic term and is defined as the potential reward that you give up when you choose one option over another. For example, say that you have $100 to spend on new clothes. If you decide to spend that $100 on a few pairs of pants, you give up the opportunity to spend the $100 on different articles of clothing such as shirts.

You can use opportunity cost to help you decide how fast to pay off your student loans. For example, say that you have student loans of $20,000 with 5% interest over a 10 year period. Assume that you have found $380 in your monthly budget to use towards these student loans.  

You decide that you want to pay off your student loans faster in 5 years. This would make your monthly payment $377.42 per month. During the course of these 5 years, you would pay out $2,645 worth of interest. If you were to have paid off the loan over the original term of 10 years, you would pay out $5,455 in interest.

On the surface then this looks like a good decision as you saved yourself $2,810 in interest. However, this is not a complete analysis of the situation. When you sent extra dollars to your student loans, you gave up the opportunity to use those dollars in other places.

What would happen if you paid the student loans off in 10 years and invested the difference since your payment would be lower. If you were to pay off your student loans in 10 years as opposed to 5, your monthly payment would be $212.

Since your payment is lower, you decide to invest the extra money from your original $380 into the stock market as you pay off your student loans. This would leave you with $168 to invest in the stock market each month ($380 original monthly budget - $212 lower monthly student loan payment).

Assume that you could get an 8% compounding return from the stock market during that 10 year period. At the end of the 10 year period, your student loans would be paid off and your stock portfolio would be worth $29,204 using the assumptions above.

So, ask yourself the question, would you rather have your student loans paid off in 5 years, or would you rather have your student loans paid off in 10 years, but also have $29,204 worth of stocks. The argument against this is that when you pay off your student loans early, you free up more of your income for other things like investing.

Would this put you in a better spot? Let's find out. If you paid off your student loans in 5 years, you would then free up $380 worth of income each month to invest in the stock market for the next 5 years. Assume again that you can get an 8% return during that time.

At the end of the 5 years, you would have $26,751 or over two grand less than what you would have if you paid off your student loans in 10 years. The point here is that understanding opportunity cost can help you decide how to allocate your resources. If your money can be better utilized elsewhere, paying off your student loans as fast as possible is not always your best bet.

In the example above, we explained how opportunity cost can help you decide how fast to pay off your student loans. In the example, it made sense to pay off your student loans over a longer period of time as you would be able to take the extra money from having a lower payment and invest it in the stock market.

The reason that that worked is because your money could earn 8% and your student loans were costing you 5%. It would not make mathematical sense to send extra dollars to your student loans as your money could be better utilized elsewhere.

However, if your student loans cost more than what your money could earn elsewhere, it is smart to pay them off as fast as possible. For example, say that you had $20,000 worth of student loans with an interest rate of 10%.

You estimate that your actual return from the stock market would only be 8% over time. Since your dollars cannot be used more efficiently in other areas, it would make sense to pay off your student loans as fast as possible.  

Although it makes sense to pay off your student loans as fast as possible in this scenario, there is a hidden opportunity cost. By paying off your student loans early, you would save interest. However, since you were sending extra money to pay down your student loans, you lost out on the interest that you could have earned from using that money elsewhere.

With that in mind, you need to repay yourself the interest that you lost out on once your student loans are paid off. You had $20,000 worth of student loans. If you did not have the loans, you could have used your money to invest in the stock market.

Assume that you could get an 8% return in the stock market. After paying off your student loans in 5 years, you need to take the next 5 years to repay yourself the interest you lost out on. Every month, you are going to save $466. When you do this, you repay yourself the interest you lost out on by paying off your student loans as fast as possible.  

We define debt as any financial obligation in which the only way you can pay it back is from money you have yet to earn. By defining debt this way, you can prioritize which debts to pay off first and which debts to pay off last.

The first type of debt you should focus on paying off is high interest debt. This would include things like credit cards and high interest personal loans. Credit cards can easily have interest rates above 20%. Your money won't be utilized better elsewhere so it is best to pay off your credit cards before paying off your student loans.

Lower interest debt would include things like your student loans. Lower interest is a bit of a loose definition as there is not a specific number that constitutes low interest. However, you can think about it like this. If your money can earn more interest than what your debt costs you, the debt is a lower interest debt.

If your money can earn more interest than what your debt costs, you don't have to focus on paying it off as fast as possible. If your money earns less than what your debt costs, it makes sense to pay off your debt as fast as possible and then repay yourself the interest you lost out on.  

False debt would include things like car loans and mortgages. These debts are false debts under the definition of debt listed above. Since cars and homes have equity as you pay off the debt, you can sell your car or home to get out of the debt.

In other words, there is another way to get out of the debt besides paying it off. If you have a mortgage or a car loan, it is not always best to pay off the loan as fast as possible. Remember, you have to ask yourself if your money could be better utilized in another way.

If you are struggling to find the money to pay off your student loans, there are a couple of things you can do. The first thing you can do is work more. We know, we know. No one likes to hear the old adage of "just work harder."

However, it is your responsibility to pay off your student loans. Even though this won't be fun in the short term, try to look at the long term. If you can pick up extra hours at your current job or if you have a commissions based job in which you could increase your paycheck, do that.

If you can't get extra hours at your current job, you can look for a second job. This might include working in a restaurant over the weekend, doing a side hustle like DoorDash at night, or many others. Again, it is not fun to have to do this, but at times it is necessary.

The second thing you can do if you are struggling to find the money to pay off your student loans is to be more efficient. Even if you don't make a lot of money, there is a good chance that you are losing money unknowingly and unnecessarily.

Review your budget to see if there is an area that you could be more efficient in. Are you subscribed to services that you don't use? Can you get cheaper car insurance by shopping for a new policy? Can you cut back on going out? Are you buying groceries from the cheapest spot?

If you scrutinize your budget, there is a good chance that you will start to find money that you are losing from being inefficient. You can then use this lost money to pay off your student loans slow or fast depending on if there is a better place that your dollars could go.

Up until this point we have made a case that you do not need to pay off your student loans as fast as possible by using logic and math if you will. However, logic and math does not take into account the emotional impact of student loans and other types of debt for that matter.

For you, your student loans may feel like a dark cloud financially. It can be hard to see the light at the end of the tunnel sometimes. If you truly believe that paying off your student loans as fast as possible will be the best financial decision for you, there is nothing inherently wrong with that.

The points we made above are simply to explain that you may be able to get your money working harder for you then paying down your student loans as fast as possible. If your dollars can earn more than what your student loans cost, it does not make mathematical sense to pay off your student loans as fast as possible.

The bottom line is that it does not always make sense to pay off your student loans as fast as possible. If your dollars can earn more than what your student loans cost you, it does not make sense to focus on paying off the student loans as fast as possible.

If your student loans cost more than what your money can earn elsewhere, it makes sense to pay off your student loans as fast as possible. Once your loans are paid off, don't forget to repay yourself the interest that you lost out on.

Although there is the logical and mathematical approach to help you decide how fast to pay off your student loans, there is also an emotional approach. If paying off your student loans fast will help your emotional or mental state, you can do so. Just understand you may be losing out on thousands of dollars.