Don’t get me wrong, not being in debt is infinitely better than being in debt. But, taking extraordinary steps to pay off certain debts early isn’t necessarily a good idea. So what does “early” mean in the context of this blog? Early means exhausting a debt sooner than if you simply made every payment over the installment period. So, if you have a loan that calls for 10 years of monthly payments “early” would mean you pay it off at 5 years.
Student loan debt is a great example of a debt that many people would LOVE to pay off early. The questions is whether or not it’s smart to do so. Here are some scenarios, pros, and cons.
Paying off with Ordinary Income
If you’re fortunate enough to make enough money that you can throw extra disposable income at the student loan balance each month or make additional lump sum payments then go for it and enjoy life without your student loan debt. But, if you’re carrying credit card debt at the same time then you’re wasting money paying off the student loan, which is likely being financed at a rate at least 50% less than your credit card interest rates. And, if those credit cards are retail store cards, where the rates are normally in the mid 20% range, you’re really wasting money. Pay off the cards first, then focus on the student loans.
Creating a Taxable Event
There is great temptation to take money either out of some sort of investment in order to pay off student loan debt. Some folks will take money from a 401K while others will sell stocks or liquidate mutual funds in order to pay off student loan debt. What you’ve just done is create a taxable event, which means you’ll have to consider the extra cost you’re paying to convert your holdings to a check. And, you also have to consider the fact that those investment do not exist any longer which means they’re not growing over time. If all of that is worth paying off a student loan, which probably has a very low interest rate and tax deductible interest, I’d be very surprised.
In Order to Improve Your Credit Scores
Student loan debt is what’s referred to as installment debt. That means you make equal payment amounts over a fixed period of time, called installments. Installment debt really takes it easy on your credit scores because it is generally secured by something, which means people are going to pay it more diligently than they would a credit card. Accelerating the pay off of installment debt, of any kind, is not going to do for your credit scores what would be done if you paid off credit card debt. My personal example,which I’ve used before, is paying off a mortgage of $249,000 and my credit scores going up 4 points. I sold the house so it wasn’t like I did anything special to pay off the debt early, like take money from rainy day funds.
Credit Reporting Expert, John Ulzheimer, is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling. He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. Follow him on Twitter here.