Pay off 4.75% loan or keep extra money in 5.05% savings?

August 12, 2007 11:31 AM

I can't decide which is the best route: pay off ~low interest student loan (4.75%) or keep extra dough in savings account (5.05%).

I realize there has been one or two questions related to this subject, although I think this is a very specific question that the responses in those questions don't necessarily apply to.

I have around 34k in student loans at 4.75% and around 20k (and growing quickly) in my EmigrantDirect account (5.05%). Since 5.05% > 4.75% I have only been making the minimum payment on my school loan since I started accruing interest in January. However, a co-worker brought up that after taxes (I'm assuming 30%) that my 5.05 is more like 3.5% and I should pay off my loan ASAP. Is this true? In the long run which will net me the money?

Other info/thoughts:
-Rest assured, if I decide to pay more on the loan I am going to leave around 6k as an emergency fund in the EmigrantDirect account.
-Perhaps it makes sense to do several things here first, before paying off the loan. Max IRA, max 401k, fund emergency account, then pay loan off?
-I don't have other debt, fyi, and make ~70k/year.

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

After taxes, your 5.05% may be really 3.5% (or whatever), but you do get a tax break on the interest on your student loans too, don't you?
posted by Dee Xtrovert at 11:35 AM on August 12, 2007

That is if I itemize, and I *think* I am still at the point where the standard deduction is greater, I could be wrong though.
posted by wolfkult at 11:39 AM on August 12, 2007

There are other banks that will offer you a better rate on your $20,000.

Personally, I would try to get my emergency fund up to the desired level (and I don't think less than a month's pay is that level) before paying off low-interest unsecured loans.
posted by grouse at 11:41 AM on August 12, 2007

A money blog I read had a similar post recently, which might help you: The Simple Dollar blog
posted by sharkfu at 12:02 PM on August 12, 2007

Actually, you don't have to itemize to deduct interest - I have almost nothing to itemize, so I take the standard deductible, and still got to take advantage of my student-loan interest.

All told, getting a solid six-month's-expenses emergency fund, then maxing out a 401(k) and IRA is far more important. Don't think of your emergency fund in terms of absolute numbers - it should be a matter of how many months it will allow you to get by without income, in the event of job-loss or similar disasters.

When I ran the numbers for myself, I decided that over the long run, the flexibility of having a lot of liquid funds outweighed my desire to get rid of my student loans. You could always split the difference, and, say, double your loan payments.
posted by Tomorrowful at 12:03 PM on August 12, 2007

From the IRS: "[I]f your modified adjusted gross income (MAGI) is less than $65,000, there is a special deduction allowed for paying interest on a student loan (also known as an education loan) used for higher education. For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return before subtracting any deduction for student loan interest. [...] The student loan interest deduction is taken as an adjustment to income. This means you can claim this deduction even if you do not itemize deductions on Schedule A (Form 1040)."
posted by xo at 12:05 PM on August 12, 2007 [1 favorite has favorites]

Your end interest will probably be closer to 4%, not 3.5. And if the above posts are correct, you can still claim the interest from your student loan. I suggest downloading a couple copies of last years tax forms and working out both ways.

Personally, I would hang on to the 20K in your savings account. The student loan is cheap money. You may soon need a car loan or mortgage, and if you have a $6000 emergency, $20000 would be a lot handier, especially if you can't work.

Max out your retirement options, make your minimum loan payments, and relax.
posted by Yorrick at 12:15 PM on August 12, 2007

I came to the same conclusion Tomorrowful did (my student loan interest is just 3.65%). Inflation and the tax deduction make it almost free.
posted by notyou at 12:16 PM on August 12, 2007

If you decide that you want to take the money out of your savings account and pay off the loan, you can do it any time.

If you pay off the loan and then decide that you need to get some money out of your savings account that isn't there any more, you're stuck.

In terms of the return and yields, your student loan interest is still probably tax deductible. I would choose not to pay off any more than the minimum on the loan. Bird in the hand, etc.
posted by ikkyu2 at 12:23 PM on August 12, 2007

I agree with Yorrick. This is cheap money. In the long run you're better off maxing retirement and keeping a nice fat safety net in savings. Worst case scenario: you lose your ability to make money and are not getting compensation then you default on your student loans instead of going straight into the poor house.
posted by damn dirty ape at 12:23 PM on August 12, 2007

You can also leverage that money in the bank. Say you want to buy a car, and get a loan for that. Go to the same bank where you have $20k in savings, and ask for a $20k loan. they don't lock down your saving account, yet they will give you the loan without a second thought. Try that with $0 in savings... you may still get the loan but terms may not be as good, etc...
posted by thilmony at 12:31 PM on August 12, 2007

You are asking a $102/year question here - (5.05-4.75)*34K - so don't over-optimize. The more important question is "what kind of money-person are you?". Is the $20K in the bank going to tempt you to spend it on something (like a car)? Or have you got it in your mind that you don't actually own the $20K - it belongs to the student loan and you are just the current caretaker. If you feel the spending temptation, I suggest you pay off some ($7K?) of the student loan.
posted by mediaddict at 12:43 PM on August 12, 2007 [2 favorites has favorites]

The numbers are pretty simple. At $70K income you are in the 25% bracket, meaning you get to keep 75% of each dollar you earn. That means that your after-tax return on your savings account is (5.05 * .75) = 3.79%. This is about 1% less than your loan rate so your savings account is losing you about $340 per year if you don't pay off your loan.

BUT, you may be able to take a deduction on your student loan. If you can deduct your loan interest, then your loan is only costing you (4.75 *.75) = 3.56% which is slightly less than the after-tax return from your savings account. So you are ahead by not pre-paying your loan.

So, here is where maxing out your 401k can help you -- your contributions to your 401k reduce your adjusted gross income. The student loan deduction begins to phase out at $50,000 if single and $105,000 if married. The deduction is eliminated at $65,000 and $135,000, respectively. So by contributing to your 401k, you reduce your adjusted gross income and increase your eligibility for the student loan deduction. You can contribute a maximum of $15,000 to your 401k. Any amount that gets your gross income below the top limit will help.

If you can keep the 4.75% loan rate, your savings account continues to yield 5% and you can take a deduction, it makes sense to keep the loan. As your income increases and your deductibility goes away, it may not make sense any more and you may want to gradually pay it down. But I wouldn't do it all at once. Having emergency cash in the bank is good for security and is a good start on a down payment for a house.
posted by JackFlash at 2:07 PM on August 12, 2007

Perhaps I've missed this, but is the 4.75% on your student loan a fixed rate? If it is fixed, I would focus on fulfilling other financial goals. You've got $20k in savings. I don't know your expenses, but perhaps you only need $10k for emergency savings (6 months $1666). You would want to be setting aside money for retirement and for a downpayment on a home. If you have a vehicle, you would want to set aside money to eventually replace it and to insure it each year.

If the rate is not fixed, you need to know its relationship to the prime rate before you can really make a decision.
posted by acoutu at 3:46 PM on August 12, 2007

Depending on how old you are you do have options based on what your objectives are.

If you are thinking of improving your credit score than save to pay off the loan in one lump sum. This will improve your credit score. If you are thinking of buying a home this may allow you to get a lower rate when you approach a lender and ultimately save you more money in the long run.

If you have no real interest in improving your credit score to acquire a lower rate loan in the future than keep the loan, max out the 401K and rent until your financial outlook changes.
posted by bkeene12 at 7:21 PM on August 12, 2007

Mortgage rates are close to 7% now. You're going to feel awfully stupid paying off that low-interest loan and taking out a higher-interest loan when you buy a house later in life when you could have used the money towards reducing the mortgage. I agree with everyone who says not to pay off the student loan until you absolutely have to. You can certainly find a better use for the money than a 4.75% return, and already have with your 5.05% bank account.
posted by commander_cool at 7:37 AM on August 13, 2007

You can certainly find a better use for the money than a 4.75% return, and already have with your 5.05% bank account.

This is not true as I explained above, on an after tax basis, which is the only way that counts. The loan costs about 1% more than the bank account earns. Only if the OP is eligible for a tax deduction of student loan interest does it become a wash.
posted by JackFlash at 8:33 AM on August 13, 2007