Student loan debt plagues some 40 million Americans and on average, graduates leave school with nearly $30,000 of debt that they’ll somehow have to pay off. If your checking account is looking healthy or you’ve gotten a bonus, it may be tempting to make a big dent in your debt balance at one time. But it’s important to look at the big picture to decide if it’s the right thing for you to do.
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A Lump Sum Payment Reduces Your Interest Amount
As a condition of borrowing money to cover your education costs, you’re expected to pay it back with interest. Rates for Federal Direct loans currently range from 4.29 percent to 6.84 percent for new borrowers, depending on the type of loan you have. If you borrowed from a private lender, you may be charged a fixed or variable rate that’s higher than 18 percent.
If a sizable part of your monthly payment is getting eaten up by interest each month, paying off a big chunk of your loans in one go will save you money in the long run. For example, let’s say you borrowed $30,000 at a rate of 5 percent. If you were to pay $320 a month toward the loans for 10 years, you could pay over $8,000 in interest before it’s all said and done. Now, if you paid down $5,000 of that debt using a lump sum and continued making your regular monthly payments, you might save over $2,500 on interest.
It’ll Speed Up Your Loan Payoff Time Frame
In addition to reducing what you’re handing over to the lender for interest, a lump sum payment would also get you closer to being debt-free faster. Going back to the previous example, making a $5,000 lump sum payment on a $30,000 debt could trim almost two years off your total repayment period, assuming you kept paying the same $320 a month. If you’re able to add on a few extra dollars to your payment each month, you could shorten it even more.
For many millennials, student loan debt has become a major barrier to other financial goals, such as saving for retirement or buying a home. If you’re able to get rid of your loans in less time, you can use the money you’ve been paying toward them each month to start building your nest egg or saving for a down payment.
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Lump Sum Payments Still Qualify for a Tax Deduction
If you’ve been making payments on your student loans all year, you can generally write off some of the interest you’ve paid at tax time. For the 2014 tax year, the limit on the deduction was set at $2,500. The deduction applies regardless of how you paid the interest so using a lump sum wouldn’t affect your ability to claim it.
There is a downside, however, if you’re paying all of your loans off at once: That’s one less deduction you’ll be eligible for going forward. Deductions reduce the amount of your income that’s subject to tax, which directly affects how much you owe or the size of your refund if you normally get one.
Make Sure You Have a Safety Net in Place
Draining your savings account to get rid of your student loans for good can work against you if you don’t have a backup plan in case of an emergency. If your car breaks down, for example, or you lose your job, it’s a good idea to have some money set aside to cover your expenses until you can get things back on track.
Pouring every penny you have into your student loans just doesn’t make sense if it means you’ll have to turn to a credit card or personal loan to cover a last-minute payment. Establishing a separate emergency fund before you start attacking your loans ensures that you won’t come up short if you have an unexpected expense.
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