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PAY OFF STUDENT LOANS OR INVEST?

60 Second Guide to Getting Out of Dept | 60 Seconds Guide to Short Term Savings | Budgeting 101 | Getting Out of Dept | How to Budget | Loans to Friends and Family | Pay Off Student Loan or Invest | Values Inventory

Worldly Investor News, 11/05/2001
by Gary Schatsky

(Editor's Note: Nationally recognized fee-only financial advisor Gary Schatsky answers readers' questions about personal finance three times a week. If you have a question
for Schatsky about investing, mortgages, taxes, retirement or any other personal finance issue, drop him an e-mail at gary@worldlyinvestor.com.)

Gary,

I have $48,563 dollars of student loans at 5.75%. With this all-time low rate thanks to the feds, should I be paying more towards the principle or should I be investing? I was thinking of putting more in bond funds and other mutual funds that could return higher interest. If I do invest extra monies then would there ever be a time that I would put a lump of those earning towards the loan?

Good question. The answer depends on a number of things, not least of which is whether the interest on these student loans are deductible from your taxes.

Clearly if the interest is not deductible paying off the loans early will be an easy recommendation as earning a guaranteed 5 3/4% on an "after-tax" basis is hard to find these days. If the interest is deductible the decision becomes a little less clear.

Does the New Law Make it Deductible?

In order to see if the interest is deductible you first have to understand the recent revisions to the tax law that have expanded the number of people who can deduct the interest. It should be noted that you don't have to itemize to take this deduction, a great advantage to millions who don't have enough deductions to itemize.

Starting in 2002 you can deduct all of the student loan interest up to $2,500 per year if you are filing single and have an adjusted gross income (AGI) of less than $50,000
($100,000 if you file jointly). This interest deduction is reduced as your income increases with no interest deductible when your income reaches $65,000 (or $130,000 if filing jointly).

More good news. The prior law also placed a time limit on when you could you could deduct the interest - specifically only for interest payments during the first 60 months that interest payments were required. The new law eliminates any time limit.

If your loan is not deductible you have to be able to invest the money and earn at least 5- 3/4%. Currently very few bond funds or CD's are paying such rates unless they are low quality bonds with significant credit risk. The only way to attempt to beat 5 3/4% is by taking some market risk. Stocks certainly should outperform 5 3/4% over the long term, but you may not have the money "long-term" as you are forced to make monthly payments.

In summary, if the interest isn't deductible pay off the student loans. If it is, it's possible to outpace 5 3/4% in the equity markets if you have the stomach and investment time horizon. You might have the first but I am unsure about the second.

In a more optimistic view of the times -- isn't it great to be able to borrow at 5 3/4%?!

Dr. Jerry Basford - The University of Utah
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