Should You Pay Off Your Student Loan in Lump Sum?
Student loan debt can be a looming financial burden that many college graduates would prefer to have off their plate. So, if you have the ability to pay a large part of it (or all of it) at once, you may want to consider the benefits and drawbacks of lump sum payments towards your college debt.
To be clear, you are in a very fortunate position to be able to get rid of a big chunk of your student loan debt. Before you make this financial move, here are some points to think about.
Benefits of Lump Sum Payments
There are many reasons to pay your student off with one lump sum -- the benefits affect you financially and mentally.
Save on interest charges
One of the biggest is the interest savings. Student loans, especially private student loans, can have high interest rates. Some might even have variable interest rates, meaning your rate could increase at any time.
Picture this scenario:
You owe $45,000 in student loans. The interest rate on the loan is 5.8% and you are on a 10-year payment plan.
Each month, you’ll pay $495.08 towards the loan. After 10 years, you’ll have paid the loan off in full. You’ll have made 120 payments of $495,08, totaling $59,409.60. That’s almost $15,000 in interest over the life of the loan, more than $1,000 per year down the drain.
If you have the cash on hand to pay the loan in full or put a major dent in it, it can save you a lot of money in interest charges.
Shorter repayment period
If you are on a set payment plan and know when you’ll have your loan paid off by making the minimum payments, a lump sum payment can reduce how long it takes to pay the loan off. If you get some extra cash, possibly as a gift or bonus from work, you can apply it towards your loan immediately. If you then continue to make your usual monthly payments, you’ll pay the loan off ahead of schedule.
Being in debt is a scary thing. If you have a lot of debt or bills to pay, it can feel like people are banging down your door to get your money. If you worry about money on a regular basis, being debt free can be a very freeing feeling. That can be reason alone to pay your student debt in a single lump sum.
Downsides of Lump Sum Payments
Despite the many benefits of paying your loan in a lump sum, there are reasons to avoid doing so.
Student loan interest tax deduction
Though you might pay a lot of interest on your student loan, there’s a tax benefit that reduces the pain of those interest payments. You are allowed to deduct up to $2,500 in student loan interest from your income when filing your federal taxes. In effect, this benefit reduces your loan’s effective interest rate. You’ll have to calculate whether that benefit lowers the rate of your loans enough that you don’t want to pay them immediately.
To be eligible for the deduction, your modified adjusted gross income (MAGI) must be below $80,000 ($160,000 for couples). If you make more than $65,000 ($130,000 for couples) you can claim a partial deduction.
Missing out on better returns
When dealing with finances, it’s important to look at your situation carefully to determine the best thing to do. Sometimes, the thing that feels like it makes the most sense is the wrong move to take.
Historically, the S&P 500 (the 500 largest companies in America) has averaged a 10% annualized return. If you have the stomach to handle the market’s volatility, you can come out ahead by investing rather than making extra payments on your loans. Just don’t discount the value of a loan payment’s guaranteed return in reduced interest charges.
Temporary effect of credit
As counterintuitive as it is, paying your loan off could reduce your credit score. When you pay your loan off, the loan account will close. That will reduce the average age of your credit accounts. If you don’t have many credit cards, this can have a big impact on your credit score.
Always Fund Your Emergency Fund First
Even if you want to pay off your student loans in a lump sum, make sure to fund your emergency fund first, no matter what.
The reason for this is that you never know when a financial catastrophe can hit. You might lose your job, get injured, need your car repaired, or have something else expensive happen. When it does occur, you want to be able to pay the bill without taking out a new loan. If you use all your cash to pay off a student loan, hoping to save on interest, you’ll just wind up paying a higher rate when you use your credit card to finance an emergency.
Aim to keep at least 3-6 months of living expenses in an online savings account. That amount of money should be enough to help you handle any catastrophe or job loss and give you a cushion to get back on your feet. Keeping the account at an online bank is a good choice because it makes the money harder to access on a daily basis. That leaves you with less temptation to spend it. Also, online banks pay the best interest rates, so the opportunity cost of not investing the cash is as low as possible.
How Do You Pay off The Remainder of Your Debt?
If you’ve decided to pay off the remainder of your debt, there’s a process to make sure you actually pay the debt in full.
The first thing you should do is contact your lender to request a payoff amount. This is the amount that you must pay to have the loan consider paid in full. This may differ from your current balance because of pending interest charges or other fees.
Usually, your lender will provide you with a payoff amount that is valid for a specific time period. Once you know how much you have to pay, send that exact amount to the lender by the deadline that they specify.
Once you make your final payment, don’t celebrate immediately. Wait for confirmation that your loan has been paid in full. Your lender should send you a congratulatory letter saying that your loan is paid. If you don’t, contact the lender to request one.
Keep this letter on hand for a while, at the very least a few years. You can use the letter to prove that you are student-debt free. That can be helpful when applying for other loans like a car loan or mortgage.
Also, check your credit report. You should see the loan marked as paid on your report. It can take up to three months for the change to be reflected on your credit report, so be patient.
What Happens If You Leave a Small Balance?
If you attempt to pay your loan off but forget to ask for a payoff amount, it’s possible that you’ll leave a small balance on the loan. This balance could be smaller than a dollar, but it will still be there.
What happens from there depends on your lender. Some lenders will require that you pay the outstanding amount. Make sure to get a payoff amount this time so that this scenario doesn’t happen again. Other lenders will simply forgive the balance, leaving you debt free.
If you accidentally leave a very small balance on a loan, there’s no harm in contacting the lender. Ask if they’re willing to forgive the balance of a few cents. In the worst case, they’ll refuse and you can ask for a payoff amount and the best way to send your final payment. In the best case, you’ll finish your phone call with one fewer debt to your name.
Paying off your student loan debt can be very freeing. If you have excess cash and can pay it off in a lump sum, it can be tempting to do so. Whether it’s a good idea to actually do it will depend on your overall financial situation.