By Kaitlin Butler, CommonBond
A bonus from your company is a great way to begin the year, especially if you have a tidy pile of student loan debt to tackle. Knowing how much of your bonus to apply to your outstanding loans is a question without a one-size-fits-all answer, but there are steps you can take to find out the right solution for you.
Your first step is to understand the tax considerations. Start by applying the appropriate tax scenario to your bonus in order to get a realistic sense of how much you'll actually be taking home instead of sending to Uncle Sam. This Business Insider article provides a great overview to help you understand the tax considerations for bonuses.
Next, turn your attention to your outstanding debt -- not just student loans, but also any credit card debt, auto loans, etc. How much do you have, and at what interest rates are you paying off each loan? A general rule of thumb is to pay off the higher interest rate loans first. If your student loans are at 6 percent, but you have sizable credit card debt accruing interest at 13 percent, then you should use your bonus to wipe out that higher credit card debt rather than your loans.
If you don't have high-interest debt, a good next step is to review the progress you've made towards financial security. For example, having an emergency fund and, in some case, retirement savings may be more important than being student loan debt-free. Liquid (immediately accessible) funds equal to six months' worth of your living expenses savings constitute a solid baseline emergency fund. If you don't have such a savings stockpile, you should consider putting your bonus there in order to ensure that you can handle any major unexpected expenses.
Another essential financial goal is retirement; while it may seem far away now, it's an important financial consideration to plan for. If your employer offers matching contributions toward retirement, you could earn free money -- a 100 percent return on your investment -- that is more valuable than a loan prepayment. A similar consideration should be made if your employer gives you the option to designate your whole bonus towards your 401(k), which could yield huge tax savings that outweigh the benefits of prepaying loans. For a general overview on the potential lifetime value of retirement savings, check out this introduction to compound interest.
Once you feel like you've addressed the above steps, it's time to review your student loan debt. You can likely enjoy the greatest benefits of prepaying if your lender supports reamortization (we do that here at CommonBond), which allows you to apply a lump sum payment to your loan principal and then adjust down your monthly payments accordingly. While you can achieve awesome peace of mind by paying off your loans, your position might be a bit different if you've locked in great interest rates, such as 3 percent or lower. Because the stock market offers returns of 4-7 percent on average, you could earn more money over time by investing that bonus rather than by paying that 3 percent loan early.
Of course since the "return" on paying down your student loans is guaranteed, many may prefer to go that route. (If you think you have great credit and might be able to qualify for a low interest rate, consider refinancing and consolidating your student loans.) For those concerned about how paying off student loans could affect their credit, check out this Huffington Post article on credit and loan repayment -- the benefits will likely outweigh any costs. You could also benefit from lowering your overall amount of debt if you're applying for new credit lines, such as a mortgage, that take into account your outstanding debt to income ratio.
Have other ideas for your bonus or tips for others paying off student debt? Leave a comment - we'd love to hear from you!
Kaitlin Butler is Content Manager at CommonBond, a student lending platform that provides a better student loan experience through lower rates, exceptional customer service, and a commitment to community. CommonBond is also the first company to bring the 1-for-1 model to education and finance.