Should you prepay your student loan?

BL : B Venkatesh :Oct 3, 2013:  

Individuals are increasingly taking a student loan to fund their higher education.

If you are one of them, you have a choice once you become gainfully employed — to either prepay your student loan or invest that additional money to create wealth to meet future life goals.

In this article, we discuss why your choice is primarily a function of your emotional well-being, and not just driven by factors such as tax benefits, prepayment penalty and interest savings.

Asset-loan linkage

For most of you, an education/student loan is your first borrowing, and certainly not the last. During your working life, you would borrow to buy a house or replace your car. There is a significant difference between your student loan and the others.

Your student loan helps in improving your human capital, which is the present value of all your future income during your working life. The problem is that many of you take up jobs in sectors that may be unrelated to the specialisation that you mastered in your business school. You may have, for instance, specialised in finance but would have started your career in a technology company. You may eventually benefit from your finance specialisation. But the immediate linkage between the borrowing cost and the creation of the asset (human capital) may not be strong.

This is quite different from a home or car loan that you take during your working life. With such loans, you typically acquire physical assets, which could appreciate or depreciate in value over time. Importantly, the borrowing leads to realising immediate tangible benefits. And that is the reason why the decision whether to prepay your student loan should be treated differently from prepaying other loans.

Given the above factors, systematically prepaying your student loan leads to better emotional well-being and helps you in crafting a disciplined path to creating wealth. How?

Emotional well-being

Suppose you start your career with post-tax monthly salary of Rs 75,000 with a monthly student-loan payment of Rs 20,000. Further, suppose you choose to repay Rs 30,000 every month including prepayment of Rs 10,000.

Having managed your living expenses without Rs 30,000 every month, you can continue doing so even after you repay the loan! You can invest this amount in mutual funds thereafter to create wealth for future needs. Of course, you could alternatively repay Rs 20,000 and independently set up a systematic investment of Rs 10,000 every month. So, why is prepayment better?

The reason has to do with your emotional well-being. In the initial years of your career, you are busy gaining a foothold in your profession. A student loan may be a cause for concern, especially, if you work in an industry whose fortunes are cyclical. Why? Worst-case scenario, you could lose your job because of industry downturn and your investment portfolio could also lose value because of market decline! What will you do?

Now, you may ask about the possibility of both events happening at the same time. The likelihood of 2008 sub-prime-like crisis happening in the near-future may be small, but the anxiety that it could happen can have a debilitating effect on your emotional well-being. And remember, your emotional strength is important to take sound financial and professional decisions.

Conclusion

The emotional stress of unpaid student loan in the initial years of your career can be overwhelming. The penalty for prepaying the loan, if any, and the personal-tax benefit on regular interest payments, assuming tax laws remain the same, cannot be meaningfully compared to the emotional stress of carrying the loan. But before you decide to prepay your student loan, create adequate emergency fund to meet situations such as temporary loss of income and medical emergencies.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in)

BLURB: Because of the characteristic of the asset that you create from your student loan, your prepayment decision is based more on your emotional well-being than on the interest cost you save by prepaying.

(This article was published on October 3, 2013)