Debt has evolved over time. In this day and age, we need to think about debt a little differently, especially federal student loans. A lot of things make federal student loan debt non-traditional, such as:
- Forgiveness opportunities (PSLF, IDR Plans)
- Interest subsidies
- Income-driven repayment plans
- Marriage and tax status can affect repayment
With that said, your repayment strategy may be a little untraditional too. There are really two paths to tackle student loan debt:
- Aggressive: Get the lowest interest rate you can to pay off your loans sooner rather than later.
- Passive: Leverage the income-driven repayment plan that gives you the lowest payment, keep your adjusted gross income low, and maximize loan forgiveness and your savings.
Anyone who does the “murky middle” road (thanks, Rob Bertman, for the term) ends up paying more out of pocket than they have to because they’re not leveraging benefits like forgiveness and not being as cost efficient with a consistent plan.
How do you know which route to take?
People with a 1.25 to 1.5x ratio of student loans to income might do best to take the aggressive approach. Those with 2x ratio or more might do better taking the passive approach. Test the numbers yourself by using our free student loan calculator.
Taking the passive approach to paying off your student loan debt can feel a little weird, almost wrong, because it is not the traditional way to think about debt.
The stigma or negative connotation surrounding debt, dare I say it, may be a little outdated, however. Why?
Debt interest rates were historically high, and people haven’t forgotten.
a. Mortgages used to have double-digit interest rates. It has just been in the last 30 years that we’ve seen rates below 9%. This year started off with an average 3.0%-3.8%.
b. Auto loans have a similar story. Auto loan interest rates in the ‘90s were close to 12% on average, coming down at the turn of the century and in the early 2000s. Now in 2020, we can reasonably expect below 5% with decent credit.
Debt used to be way more expensive to carry — no wonder people think about debt in general as downright bad.
On the flipside, interest rates on federal student loans have consistently remained between about 5% and 8% over time, even with interest rates being variable before the 2000s. This range has historically made higher education accessible and affordable.
Why would you take the passive approach?
The passive approach, however, can be a borrower’s safe haven. Over the past 15 years, debt-fueled tuition inflation has rapidly increased the student debt outstanding. People are now graduating with mortgage-sized student loan balances.
Even if you focused all of your extra cash flow on accelerating your payoff plan for your greater-than-your-income student loans, mathematically it may still take you 15 to 25 years to pay them off. And yes, you’d be debt free at that time, but what else would you have to show for it?
A $0 net worth.
You don’t want to get the “blinder effect” with your student loans because, believe it or not, the traditional “eat beans and potatoes until debts are paid off” approach may cost folks more in the long run, such as:
- Your health — debt-related stress is a real concern
- Delayed goals
- Lost time and market participation on your savings
- Little to no efficiency achieved in your payoff strategy
Focusing a large amount of your available cash flow on student loans doesn’t provide a return on your money, meaning student loan debt is not an asset-backed debt. This is important to remember. You can pay down your mortgage or your car as fast as possible to reduce your interest cost over time and be out of debt sooner. In doing so, you have equity within something, or an asset to turn around and sell. As much as you may want to, you cannot sell your degree (or your brain).
Jon makes $52,000 per year. He wants to know if he should make the sacrifices necessary to pay his $152,000 federal student loan balance off in 10 years or if there is a better approach to consider.
Jon is eligible for PAYE, which has a 20-year forgiveness timeline, and his payment would be based on 10% of discretionary income going forward starting out at $277/mo. He would want to save for the “tax bomb” in 20 years to pay the tax on his forgiven debt in 2040, making his monthly obligation toward his student loan plan $574/mo.
If he were to take the traditional aggressive pay-down strategy and pay this balance off in full in 10 years, his payment would be $1,612 to $1,743/mo. Refinancing could reduce his interest rate from 6.7% to 5%, slightly reducing his payment. This amount, however, is close to 40% of his gross income going toward his student loan plan per month.
Going the aggressive route not only soaks up almost $1000 more in cash flow per month but also costs more overall when compared to the total cost of his loan payback. The traditional approach here does not work in his favor. The passive approach can leverage the federal system in his favor, helping him have the cash flow to prioritize other financial obligations and goals.
If the aggressive approach is your path, make sure you do these things before accelerating your student loans:
- Pay off other higher interest debts.
- Credit cards are a showstopper because they are oftentimes very expensive debts to carry at interest rates upwards of 20%. Pay these off ASAP.
- Establish your emergency fund.
- For real. Having an emergency fund established is an underrated financial security necessity. Having savings to protect you against unexpended expenses or losing your income is important to help you avoid going further into debt.
- Take advantage of your employer match.
- Check to see if you have matching benefits on your retirement plan with your employer. Matching means if you contribute to your 401k or individual retirement plan, your employer will also contribute a certain percentage. Take advantage of that full match. That’s a 100% return on your money!
- Look into refinancing your student loans to reduce your interest rate.
- Refinancing can be a great tool for reducing your interest cost on your overall repayment. Consider applying through our cash-back refinancing links.
Once these financial to-do’s are checked off, go at it! Accelerate away.
The wrong approach can cost you more than just money, so making sure you assess what’s best for you is vital. Need help? Schedule a consult.