Should You Have Paid Your Student Loans During The Payment Pause?

During the payment pause and interest waiver, borrowers of eligible federal student loans were not required to make payments on their federal student loans. Since no new interest was accruing, any payments would be applied only to the principal balance of the loans.

Should you have paid down your loans during the payment pause, or should you have invested your loan payments?

Hindsight is 20/20. But, you still have a few months before the payment pause and interest waiver ends. Also, the most recent extension might not be the final extension.

What Is The Payment Pause And Interest Waiver?

The payment pause and interest waiver, which began in March 2020, suspended repayment of eligible federal education loans for more than two years during the Covid-19 pandemic. The interest rate was also temporarily set at zero. All collection activity on defaulted federal loans was also suspended. 

Eligible loans included all federal student loans held by the U.S. Department of Education. This includes all loans in the Direct Loan program, certain loans made in the Federal Family Education Loan Program (FFELP) under the Ensuring Continued Access to Student Loans Act (ECASLA), defaulted FFELP loans held by guaranty agencies on behalf of the U.S. Department of Education, and Federal Perkins Loans that have been assigned by colleges to the U.S. Department of Education. 

Commercially-held FFELP loans and private student loans are not eligible for the payment pause and interest waiver. Commercially-held FFELP loans can be made eligible by including them in a Federal Direct Consolidation Loan.

Aside from spending the money, borrowers have a few options for using the money they would otherwise have had to devote to making payments on their student loans.

• Build or bulk up an emergency fund
• Continue to make payments on the paused federal student loans
• Paying down other, higher-interest debt
• Investing the money

Let’s explore the financial impact of these options.

Option 1: Building Or Bulking Up An Emergency Fund

There was record unemployment during the pandemic, even for college-educated workers. The unemployment rates have, however, now normalized, reaching pre-pandemic levels.

You might still have your job, but who knows what might happen in a month or two?

It is a good idea to have an emergency fund with half a year’s salary, to help you survive a period of unemployment or pay for other unexpected expenses. The average unemployment spell during an economic downturn is slightly more than five months, so half a year’s salary should be enough to cover living expenses, especially if you cut spending to stretch out the emergency fund further. (Unemployment benefits can help, but tend to be anemic, averaging about the same as the poverty line for a family of four.)

Assuming your student loan debt is in sync with your income and you are in a standard 10-year repayment plan, you could have saved about a quarter of a year’s salary during the two years of the payment pause and interest waiver. If you were in an extended repayment plan with a 30-year term, you might have saved half as much by redirecting the student loan payments into your emergency fund. 

You shouldn’t make extra payments on loans or invest extra money until you have built an adequate emergency fund.

Option 2: Paying Down Your Student Loans

Of borrowers who were eligible for the payment pause and interest waiver, only 1.2% continued to make payments on their federal student loans. The entire payment was applied to the principal balance of the loan, since the interest rate was temporarily set at zero, so no new interest was accruing.

Since the interest represents as much as half of the average loan payment, continuing to make payments during the two years of the payment pause and interest waiver would have paid down the principal balance by as much as an extra year of payments, for a total of three years of progress in paying down the debt.

Consider a $30,000 student loan with a 5% interest rate and 10-year repayment term. The monthly payment is $318.20. Two years of payments totals $7,646.80. Applying this entirely to the principal balance of the loan reduces the loan balance to $22,363.20. That’s about the same as the loan balance on a regularly amortized loan after 36 payments. 

Of course, borrowers who are pursuing Public Service Loan Forgiveness (PSLF) or the 20 or 25-year forgiveness at the end of an income-driven repayment plan should not make any payments on their federal student loans when they are not required to do so. Making these payments only serves to reduce the amount of forgiveness the borrower will eventually receive. Moreover, the paused payments count toward forgiveness as though they had been made, so making the payments does not yield any extra progress toward loan forgiveness. 

Option 3: Paying Down Higher Interest Debt

Federal student loans have some of the lowest fixed interest rates on unsecured debt. 

If you are going to pay down debt, it is best to pay down debt that charges a higher interest rate, such as private student loans or credit card debt.

Paying down debt is like earning a return on investment equal to the interest rate charged by the debt, tax-free, since you no longer have to pay interest on the amount of the extra payment.

If you pay down debt which charges twice the interest rate, you double the savings.

Option 4: Investing The Money

Investing the money in the stock market might yield a higher return on investment, albeit at higher risk, than paying down debt.

Although the S&P 500 increased by about 75% from March 2020 to February 2022, the actual return on investment is slightly lower because the paused student loan payments would have been invested monthly instead of in a lump sum. Assuming equal amounts were invested on the first trading day of the month from April 2020 to January 2022, the total return on investment would have been about 23%. That’s a better return on investment than paying down student loan debt. 

Using the above example, if you have $30,000 (average debt at graduation for a Bachelor’s degree) at 5% interest, your monthly payment would be roughly $318.20 per month. Paying down the debt for 24 months would reduce it by $7,636.80.

However, if you invested that $318.20 per month in the S&P 500, you would have seen it grow to $9,387. That’s about a $1,750 difference. You could then take that same $9,387 and pay down your debt, or continue to let it grow into the future.