My fiancée has a BS in Biology and a MFA in Forensics. As you can imagine, she had to get a lot of student loans to cover the university costs. $23,000 to be exact. Fortunately, as with a lot of student loans, it is subsidized by the government. Which means her interest rate on her loan is only 2.625%.
Having recently paid off her truck, she was going to use the money she would have paid on the truck to pay down her student loans a little quicker to safe herself some interest. What she did not realize was that by paying off her student loan early, she was actually costing herself money from a missed opportunity.
There are many safe investments out there right now that are paying 5% interest. These money market and CD accounts are a great place to put your money because of their guaranteed return.
I will spare both of us the calculations on this one. They are involved and very complicated. I will however, try to explain this abstractly.
Here’s the deal. Her student loans have a 2.625% interest rate on them. She can invest money safely in at a 5% rate of return. So if she only pays the minimal every month on her student loans and uses the rest of the “former truck payment” to put CD’s, she will come out 2.375% ahead.
She still has to pay the 2.625% interest on the loan, however she is now earning 5% on the CD’s. Here is the math:
5% - 2.625% = 2.375%
Basically she is earning 2.375% by choosing not to pay off her student loans early. The government in effect is giving her low interest money that she can invest safely. There is a catch however. She must make sure she buys CD’s with the money. If she does not and spends that money on clothes, then she is costing herself money.