We have written quite a few articles and posts about student loan repayment, covering everything from the best way to pay off student loans to the repayment and forgiveness programs that are available to those facing a hardship or dealing with limited income. And believe it or not, one of the most common questions and debates that has come up time and time again in the blog comments is whether the student loan interest tax deduction should play a role in the repayment strategy. While we are hesitant to give a blanket answer that covers all situations, the short answer is “no.” Let’s take a closer look.
How the Student Loan Interest Deduction Works
You probably know this already, but a tax deduction allows you to subtract an amount from your “taxable income.” So, if you have $1000 to deduct and you make $30,000, then your taxable income will be reduced to $29,000. It’s fairly simple.
The student loan interest you pay over the course of a year is reported to you by each student loan servicer who handles one of your accounts. They report this on Form 1098-E and either mail it to you or post it to your online account. When you do your taxes, you will add up the totals and subtract them from your taxable income.
Why the Deduction should not affect your Repayment Strategy
Like we said, we don’t want to give a blanket answer, but in most cases if you go out of your way to claim a larger tax deduction, you might be sacrificing efficiency. In other words, this approach might lead to a longer payoff time for your loans and a more expensive total repayment. You see, doing it this way will force you to deviate from the best way to pay off student loans. If it’s going to cost you more time and more money—it probably isn’t worth it.
Let’s explain why this is true in theoretical terms, and then will take a look at a concrete example (math included).
We have established that the best way to pay off student loans is to pay off the account with the highest interest rate first. By doing this, you limit how much the loans will grow, and this leads to a cheaper and faster total payoff. If you have loans with the same interest rate, you pay off the smallest one first because there is no mathematical difference and you can close individual accounts more quickly. This can boost your credit and create stability.
Chasing tax deductions will throw a kink into this system even though it looks like it can save more money on the surface. We have noticed that the idea of saving on interest sometimes isn’t tangible to consumers. They don’t always wrap their heads around it and don’t really feel like they are getting ahead.
Another reason why chasing the tax break is a bad idea might sound like common sense: You will get the deduction at some point. Think about it, if you have $500 in interest that has accrued on a low-interest loan, but you also have a high-interest loan with limited interest accrued, we want you to still focus on the high-interest account. You will get that $500 tax deduction at some point. Maybe it will be next tax year, or maybe it will be gradually from year to year as you pay down that loan each month. The deduction will still come to you over time, so it shouldn’t be your top priority now.
Ok, as promised, here is some math. In our example, we are going to assume that you make $30,000 per year and that you have two loans, Loan A and Loan B. Here is some information about each loan:
|Loan A||Loan B|
Now, we are going to assume that you have $1,000 extra to put toward your loans. In this situation, you have to decide whether to put the extra money toward Loan A, like our efficient method calls for, or to Loan B in order to get the tax deduction.
Here are the results if you pay to Loan A:
|Pay $1,000 to Loan A|
|Loan A Total||$4,050|
|Loan B Total||$6,000|
|Tax Due (15%)||$4,493|
Here are the results if you pay to Loan B:
|Pay $1,000 to Loan B|
|Loan A Total||$5,050|
|Loan B Total||$5,000|
|Tax Due (15%)||$4,350|
As you can see, putting your extra money toward Loan B leads to more initial savings. When you pay Loan B, you save $150 on taxes, but paying Loan A only saves $7. That’s a difference of $143, so paying Loan B provides a short-term savings of $143 over paying Loan A.
But believe it or not, this doesn’t tell the whole story. We need to not only look at the short-term but also the long-term consequences of this decision. By paying the low-interest loan now, we have sacrificed some interest savings we could have achieved by putting our extra to Loan A. Let’s take a look at how this decision will play out over the rest of your repayment.
Let’s take a look at how different scenarios affect the total interest you will pay over time. In the two tables below, the row for “Standard Plan” shows how much interest you will pay in a 10-year plan when you pay only the minimum monthly payments. “Pay $1,000 Now” will show how much interest you will pay over the life of the loan if you apply the extra $1,000 now.
Here are the scenarios for Loan A:
|Loan A Scenarios|
|Total Interest Paid over Life of Loan||$2,302.48|
|Pay $1,000 Now|
|Total Interest Paid over Life of Loan||$1,846.37|
Here are the scenarios for Loan B:
|Loan B Scenarios|
|Total Interest Paid over Life of Loan||$1,289.57|
|Pay $1,000 Now|
|Total Interest Paid over Life of Loan||$1,074.78|
Once we have all of this information, we see a much different perspective. When we just looked at the short-term effects of trying to get the tax deduction, it looked like a great decision. But when we see the long-term results, it’s clear that there is a better option. Here’s why.
If you pay $1,000 now to Loan A, the total interest you will pay during your repayment is $3,135.94. We calculated this by adding the totals from the “Pay $1,000 Now” scenario for Loan A to the “Standard Plan” scenario for Loan B. On the other hand, if you pay $1,000 now to Loan B, the total interest you will pay during your repayment is $3,377.26.
So once we look at it this way, we can see that putting the $1,000 to Loan A is the way to go. By subtracting $3,135.94 from $3,377.26, we see that this approach will save $241.32, which is an additional $98.32 in savings from the tax savings you get by paying Loan B. But there is also an added bonus. You will still be able to deduct that $1,000 worth of outstanding interest from Loan B. You will do this over the years as you pay down that account and it will lead to even more savings with this method.
Stick to your Strategy
The long story short is this: don’t alter an efficient student loan repayment strategy just to pursue a tax deduction. You will get to deduct the interest at some point anyway, and you’re better off saving on your total interest costs, which will climb more quickly if you don’t focus on your high-interest account.
We hope this helps, and feel free to reach out to us for a student loan counseling session to address your other student loan needs.