I have paid off all my debt that was costing interest, aside from my mortgage. Now I have my federal student loan left which is at 0% interest. In my mind I feel like it needs to be paid off because it is a debt, but a financial advisor I spoke with said to just keep making the monthly payments and it doesn’t matter how long it takes to pay off since it’s not costing me anything.
Maybe they have a point, but having $300 come out of my account at the end of every month sometimes feels like a big cost to budget for when life is already so expensive right now. I do have the savings to pay the loan off in full, but then I would essentially be left with no savings. Right now my loan will be paid off in two and a half years at my current monthly payment.
Would you deplete your savings account of pay off debt that has 0% interest or just keep making your monthly payments till it’s gone? What is your reasoning for going with either plan?
When your loan’s interest rate is 0% it does not make sense to pay the debt off early, assuming the interest rate does not rise later. If you were dealing with a situation where the loan was at a promotional 0% for one year and then the rate went up to 10% after the first year, then it would make sense to pay the loan off before the rate increase. However, it sounds as though this student loan will remain at 0% interest, in which case there is no benefit to paying it off early. There are, however, incentives to not paying it back early.
Right now you have money in your savings account which could be used to pay back the loan early, but then it would be depleted. You said the loan was $300/month for 2.5 years, which means the loan is approximately $9,000 in total.
Let’s imagine both your loan and your savings account are merged together in one big pool of money. You’ve got $9,000 in debt and $9,000 in savings and a loan payment of $300/month. Combined together you basically have $0 and a $300/month cost. Over the span of 2.5 years, you’ll pay off the loan and still have a savings account of $9,000.
On the other hand, you could pay off the loan now, wiping out your savings. Which still starts you out at $0, but you no longer have the $300/month cost because the loan was completely paid at the beginning. That sounds better, right?
Well, not exactly. If you pay off the loan entirely then you should still be putting the $300/month toward replenishing your savings account. It’s important to have an emergency fund. Paying off your loan up front wipes out your loan, but also wipes out your emergency fund. So you should still be putting aside $300/month to build up your savings account. After 2.5 years you’ll still end up with about $9,000 in the bank, if you’re careful.
The main difference between the two scenarios (paying off the loan in instalments or with one lump payment up front), is the latter leaves you without an emergency fund. The total amount of money you have (savings – debt) is about the same in both scenarios, but if you pay all the loan right away then you have no savings in case of an emergency.
This makes paying off the loan in monthly payments the safer option. Another thing to consider is inflation and interest rates. Right now inflation is higher than it has been for most of the past 25 years, up around 6% at the time of writing. Which means any account you have loses its value at a rate of about 6%.
What does this mean in practical terms? Well, it means a loan worth $9,000 today would be worth about $8,460 of today’s dollars in a year. Put another way, every year you get a 6% discount on your loan. If you pay it off all at once it’ll cost you about $500 more in today’s dollars than if you pay it off in monthly instalments.
However, the money in your bank account also loses it value every year too, right? So doesn’t it balance out? It’s probably close, but your savings account probably makes between 1% and 2% interest (or it should be paying you interest). Which means while your loan is going down in value at about 6% per year, the value of your savings account is probably dropping slightly slower due to inflation, around 4% to 5%.
Put another way, savings accounts hold their value slightly better than 0% loans over time. Which means your 0% debt loses its value faster than money parked in your savings. This results in a situation where holding both $9,000 in savings and $9,000 in 0% debt and making monthly payments is going to result in you coming out slightly further ahead than if you pay off your debt in a lump sum and have both no debt and no savings.
Plus, as mentioned above, by not paying off your debt all at once, you get to keep your emergency fund. The original question pointed out that it would be nice to not be putting aside $300/month in loan payments. However, paying off the debt entirely up front means that same $300/month should be put into regrowing your emergency fund, not spent as part of your monthly budget. Also, if you’re paying your debt off in instalment, you get to keep your emergency fund which can be used occasionally if expenses come up that are above your current budget.
Basically, it’s worth it to keep your money in your savings account and slowly pay off your debt. It gives you a buffer in case of emergencies and most savings accounts will accrue a little interest, gaining a bit of value for you. When a loan has no interest rate (0%) there is no hurry in paying it off as the loan decreases in value over time, thanks to inflation.
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