Do inflation cancel my loan interest?

March 9, 2009 11:12 AM

Will my student loan interest rate and the rate of inflation cancel one another out?

Thanks to law school, I currently have about 60k in student loans. About 43k of that is locked in at 2.625% The remaining amount is locked in at 4.5%.

The long-term average inflation rate is 3.42% and, by the decade, hasn't dropped below 2.6% since the 1960s.

My question: does the inflation rate paired with my interest rate mean that I am effectively paying 1% on part of my loan and actually making 1% on the larger chuck? Logically, this seems to make sense and, following that, there is no harm and possibly even some benefit to paying these things off as slowly as possible.

Of course, I could be completely wrong and I can't find any Internet site or online calculator to back me up. Can the hive help?

posted by delosic to work & money (17 comments total)

As far as I know, yes, and not only that, the interest on those student loans is tax deductible, reducing the effective interest rate even more.
posted by zsazsa at 11:21 AM on March 9

Rather than the rate of inflation, I think you want to compare your loan interest rate to the rate of return you could be earning in a savings account, CD, the stock market, etc. Maybe this is theoretically equal to the rate of inflation on average, but it would certainly depend on what you do with the money that you don't use to pay down the loan.
posted by ecsh at 11:24 AM on March 9 [3 favorites]

Yes, your intuition is correct. However, I don't think it is fair to say that you are making 1% on your lower interest loan. Average inflation since 2000 is just slightly more than your interest rate, so you aren't making any money by that metric. Current inflation is nearly 0%, so you are currently losing money. I don't think anyone can tell you with any sort of certainty how long inflation will stay low.

What is more important is your specific situation, i.e. what you are doing with the money that you are borrowing. If the money is sitting in a savings account, earning less 2.625%, then you are losing money. If your student loan is displacing other debt (e.g. a mortgage) that has a higher interest rate, then you are coming out ahead.
posted by ssg at 11:25 AM on March 9

The missing factor is if your income actually tracks inflation. If it does, then yes. If not, then no. Much of the "middle class squeeze" has come in the form of falling wages at a time of spikes in some forms of inflation.

Also, beware that govt statistics about inflation are heavily groomed. I'm not saying they are dishonest, but that it just might not map that well to your own spending. For example, for your typical exurb-dweller gas costs have a disproportionate affect on your view of income.

I'm in the same situation with my mortgage. My conclusion was that while I am paying ~1% net loans (ie I have savings account paying 3% and a 4.25% loan) it was worth it to have the cash around in case I needed it, so no it's not worth a prepayment for me.
posted by H. Roark at 11:25 AM on March 9 [1 favorite]

For practical analysis, it's better to compare these interest rates against the tax-adjusted risk-free rate rather than inflation. Your marginal dollar can either get a guaranteed 4.5% return by paying off the 17k loan or a guaranteed (3% * (1 - marginal tax rate)) return in a CD. Consider a hypothetical stagflationary situation - even though inflation would be high, the risk-free rate of return would be low enough that paying off the loans would be a better net return.

(Hopefully if you went to all the trouble of going to law school, your income is high enough that you don't qualify for the student loan tax deduction)
posted by 0xFCAF at 11:29 AM on March 9

Forget about the rate of inflation, it has no bearing on how fast to pay off the loan. You aren't "making money" on a loan even when the interest rate is lower than the rate of inflation.

What matters is whether or not you can put your money into something that pays better interest than your loan (taxing into account taxation differences on the interest of course). If so, then you're better off doing so and making the minimum payments on the loan. Each dollar put into a higher rate investment makes more money than you lose in each unpaid dollar on your loan. Your goal is to maximize your net dollars in the future, and the rate of inflation only tells you what each dollar will be worth compared with today's dollars.
posted by FishBike at 11:32 AM on March 9

Where did you get a loan at 2.625%?
posted by sinfony at 11:40 AM on March 9

Basic rule: it's impossible to actually make money on debt unless you actively use that money for an asset which produces more income than the loan costs you. Student debt does not actually involve the purchase of any assets, so it is impossible for a student loan to produce income (unless you want to compare the job that your loan enables you to get with the job you'd have been able to get otherwise, but that's a different conversation altogether). So low interest rates, even when they fall below inflation, only mean that you loans are costing you less than they would otherwise. This may in fact reflect something of a real loss for the creditor, but all it can mean for you is lowered expenses.

This changes if you use the money you would have been directing towards debt retirement into an investment that pays more than the interest rate of your loan. You can basically factor out inflation here, because you'd have to adjust both your loan and your investment by the same inflationary variable.

So to make money here, you'd basically want to pay off your debt as slowly as possible provided you can find something to do with that money which pays more than your debt costs. With interest rates like yours (and mine) this shouldn't be all that difficult, though today's market makes that somewhat chancier. When I graduate, I'm going to start investing in high yield stocks (of companies I don't think are going to go bankrupt) and basically ignore share price. Bonds, mutual funds, and money markets are all in the toilet right now, and I'm hoping we're over the fantasy that it's possible to make money based on asset appreciation alone.
posted by valkyryn at 11:47 AM on March 9 [1 favorite]

sinfony, many educational loans are tied to prime in such a way that they're really, really cheap right now. I've got a few loans sitting at 2.25% at the moment.
posted by valkyryn at 11:48 AM on March 9

Student loan interest is only partially tax deductible, and I think if it's less then the standard deduction it won't even matter anyway.
posted by delmoi at 11:49 AM on March 9

Sounds like OP's interest rates are locked in, which means he or she consolidated back in the day when you could so so and lock in a great low rate.

Because the interest is so low, I have always paid the minimum amount (on the standard repayment plan) and banked the rest. As long as you have discipline and aren't going to blow that money, I think that it's better to have that cash around, even if it costs me an couple percent in interest in the time being. You can always pay the loan off in large installments later if you really feel like it, and that cash may be useful for another purpose.
posted by iknowizbirfmark at 11:51 AM on March 9

Here's a dumb little spreadsheet that you can play around with that will answer your question in a hands-on way:

http://spreadsheets.google.com/ccc?key=pTvtuPvaSOOkhYJXAm3WgLw

(Use File>Export to save a copy)

This assumes a fixed interest rate and a fixed inflation rate, and shows how each month, the same 50 bucks you put towards your loan is worth less and less in real-world terms. Sum up the inflation-adjusted payments and the actual payments, subtract them, and you've got a pretty good estimate of how much you've gained (or lost) by paying it off slow.
posted by chrisamiller at 12:16 PM on March 9

Listen to FishBike and valkyryn.
posted by demagogue at 12:42 PM on March 9

Inflation means that your dollar is worth less, not more. The interst on your loan and inflation work in the same direction: against you.
posted by nomad at 12:44 PM on March 9

While what valkyryn says is true (you can't make money off of loans), an interest rate lower than inflation can represent a net-gain to you, since you'll be paying your creditors less.
posted by chrisamiller at 12:55 PM on March 9

Of course, if we are entering an era of deflation (and such things do happen), interest on debt will work against you.
posted by IndigoJones at 2:52 PM on March 9

Thanks everyone for the terrific answers. I knew people smarter than me would ride to my rescue!

@sinfony - iknowizbirfmark is correct. I consolidated several years ago when the rates were super low. I got lucky!
posted by delosic at 6:58 PM on March 9