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For federal student loan borrowers facing the resumption of payments in October, today’s high interest rates present an opportunity: If you have extra money, should you pay down your loan faster, or would it be better to put it into a certificate of deposit or similar fixed income investment?
Key Takeaways
- When deciding between paying down student loan debt or investing in a CD with excess funds, the correct answer will vary based on your financial circumstances.
- Prioritizing a CD or other fixed income investment may be the right choice if you can secure an interest rate higher than the one on your student loan. However, there’s a psychological component of eliminating debt that make it understandably appealing.
- If you have a CD with a high fixed rate, you may be able to use the interest you earn as part of a strategy to pay down a student loan with a low fixed rate.
CDs for Some, Student Loan Payments for Others
Experts say the right move depends on your goals and situation, but if you can get a higher fixed rate on a certificate of deposit (CD) than the rate on your student loan, then getting a CD instead of making extra loan payments beyond the minimum required is worth considering.
Load Error
“If your interest rate on CD or investment is higher than the interest rate on the loan, you could end up having more money in the long term,” said Rob Williams, managing director of financial planning and wealth management at the Schwab Center for Financial Research.
Interest rates for federal student loans vary depending on when the loan was taken out, and many are in the 3–4% range. Those made between July 2011 and June 2013, for instance, have an interest rate of 3.4%. Meanwhile, CDs are available with rates over 5%—the best one offered in June yielded a 5.65% APY, according to data gathered by Investopedia.
The choice is one that borrowers will face this fall for the first time in years. Interest on federally-held loans will begin accumulating in September, and payments will be due in October, according to the Department of Education’s student aid homepage. Both had been suspended since March 2020 to give borrowers breathing room during the pandemic’s economic turmoil, and both were extended multiple times by the Trump and Biden administrations.
While a savvy saver will come out ahead with a higher-interest CD, the decision isn’t always a no-brainer.
“There’s an emotional side and there’s a math side and both are important,” Williams said. “On the emotional side, most people probably feel better in the end if they pay down debt that they have and have it go away.”
There are further complications, some of them working in favor of a CD or similar cash-like investments, such as a high-yield savings account or a money market account. Student loan interest is tax-deductible, mitigating the impact of interest rates somewhat.
Complications Make for No Easy Answers
A new wrinkle is coming later this year, when the Department of Education is set to launch a new income-driven repayment program that will allow many borrowers to make smaller payments, avoid interest accumulating, and have their loans forgiven after paying just a fraction of their original balance.
On top of that, it may be better to have a cash buffer on hand versus eliminating low-interest debt, Williams said, since you may need cash in case of a job loss or another emergency.
CDs can also be part of a strategy for paying down student loans.
“In the current interest rate environment, a CD is a great way to earn an attractive yield and give yourself some financial flexibility when paying student loans,” said Chikako Tyler, chief financial officer at California Bank and Trust, in an email. “For instance, say you have a student loan with a low fixed rate. While a CD offers a high fixed rate, it makes sense to put your excess savings in a higher-yielding CD and use the interest you earn to help pay down your lower-cost debt.”
Sometimes, the answer is neither: Williams said Schwab recommends people allocate their money strategically, first paying bills and high-interest debt like credit cards, then establishing an emergency fund of three to six months income, and then investing in retirement funds at least up to the level your employer will match.
CDs can play a role in building an emergency fund, Williams said. However, a savings account might be a better choice for that since the money is more accessible—taking money out of a CD before the term is up (for example, in an emergency) often comes with a penalty.
Given the complexities of the choices involved, Williams recommends consulting a financial advisor.