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For some people, the question of what to do with the next round of pandemic relief checks—which Congress is debating now—is really no question at all. If you’ve lost your job or are working reduced hours, that money is likely going toward bills, food and other necessities.
But not everyone has been affected equally, and you may find yourself with a little bit more flexibility in what you can do with the money when you presumably receive it. So why not use it to pay off some of your student loan debt?
Let’s take a look at the benefits and drawbacks of putting a windfall toward your student loans, so you can make the best choice possible.
Related: Should You Refinance Student Loans?
Why You Should Pay Down Your Student Loans
If you only have federal student loans, you may be paying a super low interest rate. But private loan interest rates can approach 10% or more depending on your creditworthiness. If this sounds familiar to you, you could benefit from paying down your student loans by:
- Paying less interest. If you have high-interest student loans, reducing the balance by paying extra principal could decrease the total amount of interest you pay over the life of the loan. Let’s say, for example, you owe $30,000 in student loans with a 10% interest rate on a 15-year term. Making a lump sum payment of $2,000 right now would save you $5,989 in total interest and let you pay off the loan about two years early.
- Taking advantage of Covid-19 forbearance. If you would normally be paying down your federal student loans, you may be thankful the government has ordered pandemic-related forbearance through September. You aren’t required to make payments, and you won’t accrue interest, but any additional stimulus could help you take a chunk out of your balance. Our federal student loan forbearance calculator can show you how. Note: Private student loans don’t qualify.
- Gaining peace of mind. Personal finance isn’t just about what makes sense mathematically. It’s also about what will make you sleep better at night. For many borrowers, becoming debt-free is more of an emotional decision than a logical one. If the psychological burden of your student loans is too much, decreasing the balance could relieve your anxiety and help you move forward.
Why You Shouldn’t Pay Down Your Student Loans
The pandemic has given federal student loan borrowers a brief respite from paying their student loans, but this interest- and payment-free time isn’t the only reason to avoid putting extra money toward your loan payments. Paying down your student loans may be a bad idea if:
- You’re working toward loan forgiveness. Borrowers working toward Public Service Loan Forgiveness (PSLF) won’t benefit from using a windfall to partially pay off their student loans. “If you pay more than needed, you could be placed in a paid-ahead status,” says Riley Poppy, a certified financial planner at Ignite Financial Planning in Seattle. “This means fewer loans will be forgiven, and it is like giving free money to the government.”
- Your interest rates are already low. If you have federal loans, your interest rates are likely already low enough that you’re better off investing in the stock market or working toward other financial goals than repaying your debt early.
- You anticipate government loan cancelation. President Biden has said he supports canceling up to $10,000 in student loan debt; other prominent Democrats have called for an even larger forgiveness package. While loan cancellation isn’t a given, it may be better to hold off on prioritizing your student loans—especially if you owe $10,000 or less—until and unless there’s a plan in place.
- You want to deduct your student loan interest. You can take a student loan interest tax deduction of up to $2,500 from both federal and private student loans.
CFP AnnaMarie Mock of HIGHLAND Financial Advisors in Wayne, New Jersey, says the tax deduction is one reason why she doesn’t recommend her clients repay their student loans early. “The interest accrued [on your student loans] is tax-deductible, which effectively lowers the rate,” she says. “For example, an individual in the 22% tax bracket would be paying an effective interest rate of 2.15% instead of 2.75%.”
6 Best Ways to Use a Windfall
If you’ve been daydreaming about what to do with a potential windfall, let some time pass before making a choice. Emotional decisions come easy, but you’ll be happier in the long run if logic and rationality prevail.
Any future stimulus check won’t be taxed, but you may have to declare other extra income you receive on your taxes. This especially applies to lottery winnings, some lawsuit settlements and certain kinds of inheritances. Plan ahead by talking to an accountant or a financial planner who specializes in taxes.
Here are alternative places to send your extra cash.
1. Pay Off Other Types of High-interest Debt
Putting a windfall toward your high-interest debt, like credit cards and some personal loans, likely will save you more in total interest than paying down student loan debt.
Go through your current loans and write down the interest rate for each loan. List them from the highest rate to the lowest rate to figure out how to prioritize your payments. If you’re able to completely eliminate a credit card or loan with your windfall, you can then add that monthly payment to your other loans.
2. Stash Cash in Your Emergency Fund
The Covid-19 pandemic revealed that most consumers don’t have a large enough emergency fund to get them through months of unemployment. That’s why many financial experts advise using a windfall to cushion your savings, even if you’re currently employed.
“A tax refund and/or stimulus check is a great opportunity to build up that cash reserve fund again,” says Ryan Greiser, a certified financial planner at Opulus LLC in Philadelphia.
The best place to store an emergency fund is a high-yield savings account, where it will outearn a traditional savings or checking account. High-yield savings accounts also are easily accessible in case you need the money quickly.
3. Save for Necessary Repairs
If you’re a homeowner, you know how it goes—just when you’re done paying for the last repair, something else breaks down. The same can be said for vehicles. Putting aside your windfall for a home or car repair will help you be prepared when the time comes.
4. Invest in Your Retirement
If you have an adequate emergency fund and your student loans are the only debt you have, then investing the windfall may be a wise—and potentially lucrative—decision.
“Financially, it may make more sense to invest that windfall money if you are confident you could earn a higher rate of return than what your current loan interest rate is,” says Kevin Burkle, a certified financial planner at HCP Wealth Planning in Neptune Beach, Florida.
If you have an individual retirement account (IRA), you can invest the windfall as a lump sum. If you have a 401(k), depositing the windfall is a little more complicated. 401(k) contributions come out of your paycheck, so you’ll have to change your payroll contributions through your employer’s human resources or accounting department.
5. Save for Major Life Changes
If you’re going through a divorce, expecting a baby, getting married or experiencing another major life change, you may want to keep the windfall for any related expenses.
6. Contribute to Your Health Savings Account
Stashing a windfall in your health savings account, or HSA, will give you an extra tax deduction and help you save for future medical expenses, like having a baby or undergoing major surgery. If you don’t use all the money, you can roll it over from year to year with no penalty.
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