What was I thinking? Help on understanding student loans please

[thrifted]

Hi Mustachians!

For the first time ever, I am excited about growing a mustache. I have always considered myself a frugal person: a thrift shopper who lives walking distance from the dry cleaner/grocery store/library/laundry mat. I contribute the max 5% to my retirement account and my employer matches 2:1.

Confession: I thought I was bad ass because I graduated undergrad in 3 years and took up a grad degree for only 1 years. I had $0 consumer debt for a long time.

Then in 2005 I bought condo with $0 down, an ARM, and i made ends meet with credit cards. i maxed out a $5k credit card within a few years and forclosed at that time.  I got out of credit card debt (26% rate 2 years in to making minimum payments on a maxed out $5k credit card) 2 years ago, make an additional $25 per month on an remaining $11k balance student loan, and no longer have credit cards. I thought my 2006 foreclosure was a hard lessened learned, but after reading MMMs website, boy do I have a lot to learn.

Me and my debt:
Current $11k student loan
2.875% interest rate
Non subsidized
Minimum payment $125
$0 credit card debt

Original principal $18k student loan
Payments to date $10k
Including $2800 interest

I plan to pay off the loan in 10 months by making at least $1000 payments monthly from this point forward.

Question: how much money am I saving by accelerating my payments? I think it's $2500 but can someone please check my math?

[twinge]

I personally wouldn't be in a rush to pay off student loans at that interest rate (I've dragged my own out at that rate for as long as possible, even though I have had adequate cash to cover since I graduated). Depending on your income level you may even receive a tax deduction on the paltry interest you are paying on the loans.

 Instead, I would invest those savings as much as possible (e.g., you could max out a Roth IRA) and are you sure  the max you can contribute to your work retirement account is 5% --that may be the max they pay a match for but the max for  typical work retirement accounts in the US (e.g., 401ks, 403bs and the like) for 2012 for your contributions is $17500. 

[gdborton]

I agree with twinge 2.8% is really low, if you have any other debt you may want to tackle that first.  Are you already contributing to retirement accounts?

[jpo]

According to http://www.bankrate.com/calculators/mortgages/mortgage-calculator.aspx, it looks like you'll save about $1100 in interest. I'm guessing you have 8 years left on your loan based on the $125 payment schedule.

If you're more likely to spend than invest that extra $1000, putting it into your student loan is a great plan.

[thrifted]

hi everyone!  incredibly helpful and eye opening!

jpo - thanks for finding a good calculator for me.  i was only able to find how-much-minimum-payment-can-you-expect types for recent grads? i would be more likely to spend so i'm trying to figure out where to lock the money away.  saving $1100 in interest sounds fricken awesome to me!!

gdborton - i have no other debt at this time.  and i am contributing to retirement only the max 5% to get the 2:1 match. i have $28k so far... after 10 years of full time employment.

twinge - i think i'm starting to understand.  so even though i paid $2800 in interest over the years, i actually got it back in my tax return. to some extent.  i reported interested every year, i know that for sure.  http://blog.turbotax.intuit.com/2011/06/10/are-student-loans-tax-deductible/ apparently i can deduct up to $2500 as of 2010.  i'll be sure to ask my tax accountant (my mom) about this when i file 2011.

5% is the max for the match so i will definitely contribute more to retirement now, up to the $17500.  what are the benefits to the roth ira?

[twinge]

so even though i paid $2800 in interest over the years, i actually got it back in my tax return

Well, you reduce your AGI (Adjusted Gross Income) which reduces your tax burden so you don't get it ALL back.  It's just important to know this so you can genuinely compare values.  Yes, it's great to have "saved" $1100 in interest, but let's say if you figure in lost tax savings that equals $825 savings (just guess-timating here).  Then you have to think about the say $6000 you spent to pay that down ahead of time.  What could you have made by investing that in a a tax-advantaged account?  I would likely say quite a bit more than that $825 in interest.  Though there's somewhat more risk involved.  But you can beat a 2.875 interest rate fairly easily with a relatively safe balance of investments. When you add in the tax effects, it's very, very likely that you would do better by investing.  BUT as jpo notes, if you're likely to spend rather than invest that 1000/mo, then you're better off paying off the loan.

so even though i paid $2800 in interest over the years, i actually got it back in my tax return

  A Roth IRA has no tax deduction now, but you pay no taxes on capital gains.  If you're in a lower income bracket now than when you retire OR if you think taxes are going to be higher in the future, a Roth IRA make sense.  The other advantages are you can always withdraw contributions without penalty making it a good supplementary emergency fund, and you can withdraw more than just contributions for purchases like a downpayment for your first home, or some higher education expenses.  So it's more flexible than a 401k and affords some tax diversification.  You can only put in 5K a year though and it's phased out at higher income levels.  It's often a particularly good option when you're young-ish because the capital gains will have a long time to grow tax free and your income is likely lower than it will be later.

[thrifted]

thanks for all the clarification, twinge!  i cannot tell you how hard it took me to wrap my head around this. 

i am going to try to invest over the next few months and see how that goes.  wish me luck!

[Guitarguy]

Our loans are sitting between 5.6-6.8% so my wife and I decided that it's basically a wash. Any extra money we have for retirement gets split 50/50. Half of it goes to extra payments on student loans and half of it goes to retirement.

Rationale: We have no way of knowing whether our investments will really perform better than 6.8% over the next ten years, so instead of wasting time and energy optimizing an extra 1-2% rate of return, we're focusing on increasing our savings by 10-20%.

It's much more statistically likely that you'll beat a 2.875% rate of return in the market over the next decade, so in your case it makes sense to move the extra money into an investment account. If it makes you feel better, take 15% of what you would have put into the investment account and pay it extra on the loan instead.

[simonsez]

Receiving the tax deduction for the student loan interest is pretty easy.  Since you are out of school, the form you will be using is the 1098-E.  This should be available just like your W-2's probably some time in February or early March.  I login to my federal student loan account and can view/print it off right there.  The cool thing is that it's not something you get only if you itemize, everyone gets it (with income restrictions of course).  But I mean you can take the standard deduction AND reduce your taxable income by up to $2500.

As for how much money you would be saving by accelerating your payments (vs. paying the standard or minimum amount), that is hard to say without the exact payment schedule and the breakdown of interest vs. principal.  However, I agree with others that with your low rate, you might be better off investing the extra disposable money.