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Paying off a student loan early: pros & cons
By Desmond Chow - Senior Financial Advisor 29 October 2018 4 min read
Most of us graduate college or university with student loan debt. Like any debt, student loans are varied, come with different interest rates and penalty costs and like any debt, you’ll feel a whole lot better once it’s paid off.
Your first instinct might be to pay off your student loans as quickly as possible, but there are a few things to consider. Your financial situation, the type of student loan you have, potential penalty fees and your financial plans for the future all play into whether or not paying off your student loans early is the best thing to do.
Things to consider about your student loans.
Interest rates for Canadian student loans are either fixed, prime +5% or floating, prime +2.5%. If you have a variable rate loan and the prime decreases, you will pay less interest on your student loan. If the prime rate increases you will pay more interest.
Loans under the Canada Student Loans program are payment-free until 6 months after the student graduates or leaves school. Although payments are not required, interest is charged throughout this period. Lump sum pre-payments as well as increased monthly payments are allowed and these payments go to reduce the principal amount of the loan.
When filing your tax return, a student can claim a non-refundable tax credit for interest paid, even if someone else paid the interest. Since it’s a non-refundable credit, you can’t use it to get a refund. Instead, you can only use it to reduce any tax you owe to zero. Your tax credit is calculated as the interest amount paid multiplied by the lowest federal/provincial tax rate. Let’s consider an example:
If you paid $2,500 in interest, you’ll receive a tax credit equal to $625. Calculated as $2,500 x 15% to offset federal tax, plus $2,500 x 10% to offset Alberta Tax. In other words, you will pay $625 less in tax, but you are still out of pocket $1825 ($2,500 minus tax credit of $625). So although the tax credit is beneficial, it is not as beneficial as paying off the loan sooner and paying less total interest over time.
Since the tax credit is non-refundable, you should not claim your student loan interest during a year when you don’t owe a lot of taxes. Instead, save the claim and carry it forward to a future year. The CRA allows you to carry forward student loan interest for five years. Keep in mind, this tax credit applies only to loans granted under a government program. Interest paid on a loan that has been renegotiated with a financial institution would not be eligible for this tax credit.
The reality for most new grads is that you cannot pay off your entire student loan right away, so taking advantage of the tax credit is a must, while paying off the principal as much as you can. Every dollar you pay in interest is a dollar you’ll never see again.
Penalty fees vs accrued interest: If you think that you will save money paying the early-payment penalty cost compared to how much interest you are going to pay over time, it may be beneficial to pay off your student loans early.
2. Consider your personal situation and long-term goals.
If carrying debt gives you a knot in your stomach, you might find greater benefit in paying off your student loans quickly. Not only will it reduce your monthly debt obligations and lower your debt to income ratio, you are guaranteed a return on that money by avoiding future interest and can even start putting those monthly payments into a retirement savings plan. For some, getting rid of the stress that comes with debt is the most important reason to pay off student loans early.
If you’re okay with carrying some low-interest debt, you can create a long-term financial plan that still allows you to save while paying off your student loans over time. For example, money used for early repayment can be invested elsewhere and go towards your retirement savings plan. If the interest rate on your debt is less than the average return on the market, you could potentially do better putting that money on the market. That said, you should also consider the risk of investing and seek the advice of a professional financial advisor.
3. Meet with a Financial Advisor
If you’re still not sure what will be most advantageous for your personal situation, meet with an ATB Financial Advisor. They can help make sense of your student loan details including interest rates, penalties or added fees for early prepayment. They will also review your current financial situation and create a plan that will help you reach your long-term financial goals.
It's important to find a balance between paying off debt, investing for the future but having fun doing the things that make you happy. Don’t let stress get in the way of achieving all of this, help is available to you!