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Financial Planning / Tax Strategies


Subject:  Re: Credit Card Debt Vs. Student Loans Date:  2/15/2001  12:36 PM
Author:  dripton Number:  46524 of 130961

I have approximately the same amount of credit card debt and outstanding student loans, both of which I am trying to pay off. I have consolidated all of my credit card debt onto a 2.9% card (intro rate, but I've been able to shift the debt around onto different intro rates and have done so pretty successfully). My student loans are roughly at a 8.125%-9.00% rate. I want to pay both sides down.

My question is this: Should I focus on the credit card debt and make more than minimum payments and just make the minimum payment on student loans because that interest is deductible whereas credit card debt is not? I know I should pay both off as soon as possible, but for some reason it kind of makes sense to me to make minimum payments on student loans because that interest is tax-deductible.

You should pay off the loan with the highest after-tax interest rate first, making minimum payments on the other. Once the first loan is gone, you can then focus on the other one.

To compare the after-tax rate for a loan whose interest is tax deductable, you need to know your marginal tax rate so we can quantify the benefit of the tax break. Since you're in the income bracket where student loans are still tax deductable, you're in either the 15% or 28% percent federal bracket. You didn't say where you live, so we don't know about state or local taxes.

Anyway, if you have a marginal 28% federal tax rate, and a 0% marginal state tax rate, and you're far enough into the 28% percent bracket that all of the student loan interest deduction applies at that rate and none at the 15% rate, then you basically pay 72% of the interest on the student loan, and Uncle Sam picks up the other 28%. (If you're in the 15% bracket, then you pay 85% and US pays 15%. The lower your tax bracket, the less benefit you get for tax deductions.)

8.125% * 72% = 5.85%. 8.125% * 85% = 6.9%. The tax deductability certainly helps, but the student loan interest is still at least twice as expensive as the 2.9% intro rate. Therefore, as long as you can keep getting 2.9% intro rates, you should concentrate on reducing the student loan balance rather than the credit cards.

The danger with this strategy is that if you still have a large credit card balance and the industry decides to stops offering cheap intro rates, you might be stuck with a high-interest credit card balance in the future. You can move balances from card to card, but you can't move them from card back to student loan. So keep a close eye on the credit card industry so you can switch strategies if they do.

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