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Paying off a student loan early: pros & cons

Many people graduate post-secondary with student loans. Learn the advantages and disadvantages of paying off student loans early.

By ATB Financial 29 October 2018 4 min read

Paying for school looks different for everyone—whether that’s using RESP savings, getting a part-time job, applying for scholarships, getting a loan or a little bit of everything. If you went with student loans to make school more affordable, you wouldn’t be alone. Around half of those who graduate college or university will have student loan debt

Just like the many ways there are to pay for post secondary education, you’ve got options when it comes to repaying any student loan debt you needed to pick up along the way. 

Your first instinct might be to pay them off as soon as possible, but that might not be the best route for you. Your financial situation, the student loan type, potential penalty fees and your financial plans for the future all play into whether or not paying off your student loans early would be your best option.

Here are the things you’ll need to think about to make student loan repayment work for you.

 

1. Interest

Here’s how interest works on student loans: interest rates for Canadian student loans are either a default floating (variable) interest rate equal to the prime rate or a fixed interest rate equal to the prime rate + 2% (check out our list of common terms if you’re feeling confused). If you have a variable rate (or floating rate) loan and the prime decreases, you’ll pay less interest on your student loan. If the prime rate increases, you’ll pay more interest.

Common Terms

  • Prime rate: the baseline interest rate at which all floating rates are loans are negotiated. 

  • Default floating interest rate: an interest rate that will change over the course of paying off your loan. 

  • Fixed interest rate: an interest rate that does not change for a set period or the entire term of your loan. 

  • Principal amount: the amount owing on your loan, not including interest. 

  • Accrued interest: the interest that adds up over the course of your loan that hasn't been paid yet.

Loans under the Canada Student Loans program are payment-free and don’t accrue interest until six months after you graduate or leave school. You can make lump sum pre-payments or increased monthly payments to reduce the principal amount of the loan.

As a result of COVID-19 no interest is being charged on Canada Student Loans and Canada Apprentice Loans until March 31, 2023.

When filing your tax return, you can claim a non-refundable tax credit for interest paid on your student loan, even if a related person (like your parent or spouse) paid the interest instead of you. Since it’s a non-refundable credit, you can’t use it to get a tax refund. Instead, you can use it to reduce any tax you owe to zero. Your tax credit is calculated as the interest paid multiplied by the lowest federal/provincial tax rate. Here’s an example:

Student Loan Tax Credit


If you paid $2,500 in interest, you’ll calculate $2,500 x 15% to offset federal tax, plus $2,500 x 10% to offset Alberta tax. That gives you a tax credit equal to $625. In other words, you’ll pay $625 less in tax, and be out of pocket $1,825 ($2,500 minus tax credit of $625). Although the tax credit is a great perk, it’s not as beneficial as paying off the loan sooner and paying less total interest over time.

Since the tax credit is non-refundable, you shouldn’t claim your student loan interest during a year when you don’t owe enough tax to fully use the credits. 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 given under a government program. Interest paid on a loan that’s been renegotiated with a financial institution wouldn’t be eligible for this tax credit.

If you can’t pay off your entire student loan right away, taking advantage of the tax credit is a must, while paying off the principal as much as you can. Any amount you pay in interest is money you’ll never see again, so any way you can reduce the amount you pay in interest is a great option.

Penalty fees vs accrued interest: If you think that you’ll save money paying the early-payment penalty cost compared to how much interest you’re going to pay over time, you could benefit by paying off your student loans early.

 

2. Consider your personal situation and long-term goals

The way you pay back your student loans is personal. If having debt causes you stress, it might be better for you to pay off your student loans quickly. Not only will that reduce your monthly debt obligations, you’re guaranteed a return on that money by avoiding future interest and could even start putting what you would have paid in interest toward savings for your goals—whether that’s retirement, your own place or another big investment. For some, getting rid of the stress that can come with debt is the most important reason to pay off student loans early.

If you’re okay with carrying some low-interest debt, you may be able to save while paying off your student loans over time. Talking with a financial advisor might be the best next step for you.

 

3. Meet with a financial advisor

If you’re not sure what works best for you or you need some guidance, you can always talk with an ATB Wealth Advisor. They can help you make sense of all the investment jargon, your student loans and work with you to create a plan to repay your way.

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