With total student loan debt in the United States approaching $1.4 Trillion dollars, I seem to be having this conversation more and more with clients. The amount of student loan debt is piling up and it’s putting the next generation of our work force at a big disadvantage. While you yourself may not have student loan debt, at some point you may have to counsel a child, grandchild, friend, neighbor, or a co-worker that just can’t seem to get ahead because of the financial restrains of their student loan payments. After all, for a child born today, it’s projected that the cost for a 4 year degree including room and board will be $215,000 for a State College and $487,000 for a private college. Half a million dollars for a 4 year degree!!
The most common reaction to this is: “There is no way that this can happen. Something will have to change.” The reality is, as financial planners, we were saying that exact same thing 10 years ago but we don’t say that anymore. Despite the general disbelief that this will happen, the cost of college has continued to rise at a rate of 6% per year over the past 10 years. It’s good old supply and demand. If there is a limited supply of colleges and the demand for a college degree keeps going up, the price will continue to go up. As many of us know, a college degree is not necessarily an advantage anymore, it’s the baseline. You need it just to get the job interview and that will be even more true for types of jobs that will be available in future years.
No Professional Help
Making matters worse, most individuals that have large student loan debt don’t have access to high quality financial planners because they do not have any investible assets since everything is going toward paying down their student loan debt. I wrote this article to give our readers a look into how we as Certified Financial Planners® help our clients to dig out of student loan debt. Unfortunately a lot of the advice that you will find by searching online is either incomplete or wrong. The solution for digging out of student loan debt is not a one size fits all solution and there are trap doors along the way.
The first step in the process is to the collect and organize all of the information pertaining to your student loan debt. Create a spreadsheet that lists the following information:
- Name of Lender
- Type of Loan (Federal or Private)
- Name of Loan Servicer
- Total Outstanding Loan Balance
- Interest Rate
- Fixed or Variable Interest Rate
- Minimum Monthly Payment
- Current Monthly Payment
- Estimated Payoff Date
Now, below this information I want you to list January 1 of the current year and the next 10 years. It will look like this:
January 1, 2018
January 1, 2019
January 1, 2020
Each year you will record your total student loan debt below your itemized student loan information. Why? In most cases you are not going to be able to payoff your student loans overnight. It’s going to be a multi-year process. But having this running total will allow you to track your progress. You can even add another column to the right of the “Total Balance” column labelled “Goal”. If your goal is to payoff your student loan debt in five years, set some preliminary balance goals for yourself. When you receive a raise or a bonus at work, a tax refund, or a cash gift from a family member, this will encourage you to apply some or all of those cash windfalls toward your student loan balance to stay on track.
Order of Payoff
The most common advice you will find when researching this topic is “make minimum payments on all of the student loans with the exception of your student loan with the highest interest rate and apply the largest payment you can against that loan”. Mathematically this is the right strategy but we do not necessary recommend this strategy for all of our clients. Here’s why……..
There are two situations that we typically run into with clients:
Situation 1: “I’m drowning in student loan debt and need a lifeline”
Situation 2: “I’m starting to make more money at my job. Should I use some of that extra income to pay down my student loan debt or should I be applying it toward my retirement plan or saving for a house?”
Situation 1: I’m Drowning
As financial planners we are unfortunately running into Situation 1 more frequently. You have young professionals that are graduating from college with a 4 year degree, making $50,000 per year in their first job, but they have $150,000 of student loan debt. So they basically have a mortgage that starts 6 months after they graduate but that mortgage payment comes without a house. For the first few years of their career they are feeling good about their new job, they receive some raises and bonuses here and there, but they still feel like they are struggling every month to meet their expenses. The realization starts to set in the “I’m never going to get ahead because these student loan payments are killing me. I have to do something.”
If you or someone you know is in this category remember these words: “Cash is king”. You will hear this in the business world and it’s true for personal finances as well. As mentioned earlier, from a pure math standpoint, they fastest way to get out of debt is to target the debt with the highest interest rate and go from there. While mathematically that may work, we have found that it is not the best strategy for individuals in this category. If you are in the middle of the ocean, treading water, with the closest island a mile away, why are we having a debate about how fast you can swim to that island? You will never make it. Instead you just need someone to throw you a life preserver.
Life Preserver Strategy
If you are just barely meeting your monthly expense or find yourself falling short each month, you have to stop the bleeding. In these situations, you should be 100% focus on improving your current cash flow not whether you are going to be able to payoff your student loans in 8 years instead of 10 years. In the spreadsheet that you created, organize all of your student loan debt from the largest outstanding loan balance to the smallest. Ignore the interest rate column for the time being. Next, begin making the minimum payments on all of your student loans except for the one with the SMALLEST BALANCE. We need to improve your cash flow which means reducing the number of monthly payments that you have each month. Once the month to month cash flow is no longer an issue then you can graduate to Situation 2 and revisit the debt payoff strategy.
This strategy also builds confidence. If you have a $50,000 loan with a 7% interest rate and two other student loans for $5,000 with an interest rate of 4% while applying more money toward the largest loan balance will save you the most interest long term, it’s going to feel like your climbing Mt. Everest. “Why put an extra $200 toward that $50,000 loan? I’m going to be paying it until I’m 50.” There is no sense of accomplishment. We find that individuals that choose this path will frequently abandon the journey. Instead, if you focus your efforts on the loans with the smaller balances and you are able to pay them off in a year, it feels good. Getting that taste of real progress is powerful. This strategy comes from the book written by Dave Ramsey called the Total Money Makeover. If you have not read the book, read it. If you have a child or grandchild graduating from college, if you were going to give them a check for graduation, buy the book for them and put the check in the book. Tell them that “this check will help you to get a start in your new career but this book is worth the amount of the check multiplied by a thousand”.
Situation 2: Paying Off Your Student Loans Faster
If you are in Situation 2, you are no longer treading water in the middle of the ocean and you made it to the island. The name of this island is “Risk Free Rate Of Return”. Let me explain.
Individuals in this scenario have a good handle on their monthly expenses and they are finding that they now have extra discretionary income. So what’s the best use of that extra income? When you are younger there are probably a number items on your wish list. Here are the top four that we see:
- Retirement savings
- Saving for a house
- Paying off student loan debt
- Buying a new car
Don’t Leave Free Money On The Table
Before applying all of your extra income toward your student loan payments, we ask our clients “what is the employer contribution formula for your employer’s retirement plan?” If it’s a match formula, meaning you have to put money in the plan to get the employer contribution, we will typically recommend that our clients contribute the amount needed to receive the full employer match. Otherwise you are leaving free money on the table.
The amount of that employer contribution represents a risk free rate of return. Meaning, unlike the investing in the stock market, you do not have to take any risk to receive that return on your money. If your company guarantees a 100% match on the first 5% of pay contribution out of your paycheck into the plan, your money is guaranteed to double up to 5% of your pay. Where else are you going to get a 100% risk free rate of return on your money?
Start With The Highest Interest Rate
Now that you have extra income each month you can begin to pick and choose how you apply it. You should list all of you student loans from the highest interest rate to the lowest. If it’s close between two interest rates but one is a fixed interest rate and the other is a variable interest rate, it’s typically better to pay down the variable interest rate loan first if interest rates are expected to move higher. Apply the minimum payment amount to all of your student loan payments and apply as much as you can toward the loan with the HIGHEST INTEREST RATE. Once the loan with the highest interest rate is paid off, you will move on to the next one.
Again, by applying more money toward your student loans, those additional payments represent a risk free rate of return equal to the interest rate that is being charges on each loan. For example, if the highest interest rate on one of your student loans is 7%, every additional dollar that you are apply toward paying off that loan you are receiving a 7% rate of return on because you are not paying that amount to the lender.
Here is a rebuttal question that we sometimes get: “But wouldn’t it be better to put it in the stock market and earn a higher rate of return?” However, that’s not an apple to apples comparison. The 7% rate of return that you are receiving by paying down that student loan balance is guaranteed because it represents interest that would have been paid to the lender that you are now keeping. By contrast, even though the stock market may average an 8% annualized rate of return over a 10 year period, you have to take risk to obtain that 8% rate of return. A 7% risk free rate of return is the equivalent of being able to buy a CD at a bank with a 7% interest rate guaranteed by the FDIC which does not exist right now.
But Can’t I Deduct The Interest On My Student Loans?
It depends on how much you make. In 2018, if you are single, the deduction for student loan interest begins to phaseout at $65,000 of AGI and you completely lose the deduction once your AGI is above $80,000. If you are married filing a joint tax return, the deduction begins to phaseout at $135,000 of AGI and it’s completely gone once your AGI hits $165,000.
Also the deduction is limited to $2,500.
However, even if you can deduct the interest on your student loan, the tax benefit is probably not as big as you think. Let me explain via an example. Take the following fact set:
- Tax Filing Status: Single
- Adjusted Gross Income (AGI): $50,000
- Outstanding Student Loan Balance: $60,000
- Interest Rate: 7% ($4,200 Per Year)
First, you are limited to deducting $2,500 of the $4,200 in student loan interest that you paid to the lender. At $50,000 of AGI your top federal tax bracket in 2018 is 22%. So that $2,500 equals $550 in actual tax savings ($2,500 x 22% = $550). If you want to get technical, taking the tax deduction into account, your after tax interest rate on your student loan debt is really 6.08% instead of 7%. Can you get a CD from a bank right now with a 6% interest rate? No. From both a debt reduction standpoint and a rate of return standpoint, it probably makes sense to pay down that loan more aggressively.
Striking A Balance
When you are younger, you typically have a lot of financial goals such as saving for retirement, paying off debt, saving for the down payment on your first house, starting a family, college savings for you kids, etc. While I’m sure you would like to take all of your extra income and really start aggressively reducing your student loans you have to determine what the right balance is between all of your financial goals. If you receive a $5,000 bonus from work, you may allocate $3,000 of that toward your student loan debt and deposit $2,000 in your savings account for the eventual down payment on your first house. Creating that “goal” column in your student loan spreadsheet will help you to keep that balance and eventually lead to the payoff of all of your student loans.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.