With the stock market having one of it’s worst days (perhaps the worst day?) since 1987, it seems like a foregone conclusion that coronavirus will cause a recession.
You might be worried about many other things besides your student loans, and I’ll address those concerns. That said, having a plan for what to do about your biggest liability has a positive effect on every area of your finances.
One thing I definitely worry about is if some of the readers of this site who used us to refinance their student loans will struggle. Others will forget to update their income driven payments after losing their jobs. Still others will lose far more in investing than the entire balance of their student loans.
Regardless of what your student loan strategy is, heed these 5 tips and you’ll be far better prepared than others around you to weather a recession from COVID-19.
1. Prepare for a Drop in Income
How stable is your job? If it’s in healthcare, or you’re a top performer, you’re probably fine.
If you’re in sales or something that’s cyclical with the economy (ie RV sales, real estate broker, investment banker, etc.) then you could have a huge drop in income if Coronavirus pushes us into a global economic recession.
Borrowers in unstable jobs need to be careful about committing to a huge student loan payment. That’s especially true when you can use REPAYE to subsidize half the interest your required payments do not cover.
Remember that if your income goes down, you can simply request that your loan servicer recalculate your monthly payment. If you were to lose your job, but you plan to eventually pay off your student debt, you could lower your payments to $0 a month and receive a 50% subsidy on all of your interest under the REPAYE plan.
If you want to lower your interest by refinancing, you can do so if you have the following characteristics.
- Large cash savings (6 months of expenses with a secure job, 1 to 2 years of expenses with a less secure job)
- Low fixed costs like mortgage or car payments (30 year fixed rate mortgage + no car payments is ideal)
- A spouse with a stable income, especially in a different field (this diversifies your job market risk)
You’re probably thinking that there’s no way you could lose your job. Remember that in a recession a lot of really good people get let go just because companies cannot afford to keep everybody on. Prepare for that.
2. You Might Not Be Able to Refinance Anything
I used to be a bond trader in my former career. There are 2 components to getting a loan as a consumer.
- What are interest rates in the economy?
- What is your credit risk based on what’s going on in the economy?
If you have good credit, you generally will get a better interest rate when you borrow than if you have worse credit.
But overall, student loan borrowers are much riskier to lend to than the US government, which is the risk free borrower globally.
Right now, interest rates might be very low, but credit risk is exploding and getting very high.
What does that mean for you?
Look at this graph showing the extra yield investors demand right now above what the government borrowers at for a BBB rated corporate bond.
This is a proxy for credit risk in the economy.
Assume a bank setting student loan refinancing rates has a formula for what they charge that goes like this:
- 10 year US treasury + BBB corporate yield + 2%.
Two weeks ago, that math would’ve looked like 1% + 1.25% + 2% = 4.25%.
On March 11, that math would be 0.80% + 2.5% + 2% = 5,3%.
What If Credit Spreads Get Worse?
That chart I showed you above looks really bad. It’s not at all historically. Here’s credit spreads over time, also using Federal Reserve Data.
In 2008, investors demanded 8% additional yield for low quality corporate bonds compared to treasuries.
Here’s what the yield on refinancing would look like using the formula above:
- 0.80% (10 year yield on Treasuries) + 8.00% (credit spread) + 2% (individual borrower risk) = 10.80%.
It’s unlikely that we would have a repeat of 2008, even with Coronavirus wreaking havoc on global markets.
That said, even if we had a mild recession, investors might require an extra 4% or 5% interest for lending to risky borrowers. That could make student loan refinancing unattractive compared to keeping your federal student loan interest rates.
Plenty of readers are still refinancing their loans through this site. But that could stop in a recession.
Other kinds of debt you have, such as mortgage debt, would likely be unable to be refinanced if a recession happens. So you’d want to attempt to lower your interest on any loan that you’re not pursuing forgiveness for right now.
3. Get an Emergency Fund Now
Some in the financial independence community have said that their emergency fund is their holdings in the Total Stock Market Index Fund.
I doubt these individuals lost money in 2008.
The first step on the road to not allowing money ruin your life is to get an emergency fund of cash in the bank.
That emergency fund could be placed in a bank, credit union, or a high-yielding FDIC insured account like Betterment.
In a recession, you need 6 months of expenses with a stable job. If you have an economically sensitive job, you need at least 1 year of expenses in accessible cash. You need to include your required student loan payment as part of this calculation.
If you have a lot of credit card debt, then you need to get a budget with something like ynab.com, earn extra money by working more, and cut your spending so you can get to stability as fast as possible.
The time for making drastic cuts if you aren’t financially secure is not when you just found out you’re getting laid off.
4. Consider Lowering Your Student Loan Payment
Yes, I just committed heresy.
Remember 2008 though. If you had excess capital during that time, you made a huge sum of money investing in markets at the lowest level they will probably ever be at.
That’s the investing vs. paying off debt argument for reducing your payments. There’s also an economic argument.
If your income falls or you got laid off, then you would love and appreciate a lower monthly payment.
Lowering Your Payment If You Have or Are Thinking About Refinancing
Every couple weeks I get an email from a doctor or dentist who was so gung ho about getting out of debt that she refinanced to a 5 or 7 year term only to end up with a $10,000 a month payment with nothing left over for day to day expenses.
There’s nothing wrong with a short refinancing term, but I’d suggest starting off with a longer term to reduce the required payment. We suggest 15 or 20 year fixed as the first step in refinancing.
After you pay off a bunch of the balance, you’ll find you’re likely able to refinance to a 10 year for the same payment. If you cannot, you’ll be glad you have extra money and a lower required payment.
I’ve coined this the student loan refinancing ladder.
If you’re already on an aggressive payment, then you might want to consider lowering it while long term rates are at the lowest level they’ve been at in a long while.
You are allowed to refinance even to a higher interest rate, although you should only do that if you’re seriously concerned your required payment could end up being too high during a recession.
Lowering Your Payment If You’re Pursuing Forgiveness and Income Driven Repayment
If you sustain a drop in income or if you were to get laid off, then you should update your monthly payment immediately with your loan servicer.
You might need to show a pay stub or sign a written promise that the new income you report is accurate.
Just remember that “income driven” payments mean based on the income you had and currently have.
If the current income is lower than your prior year taxable income, you can update it immediately.
If your current income is higher than your prior year income, you can wait until the next time you need to re-certify to tell your servicer.
5. Maintain a Long Term Investing Plan
You should be contributing a minimum of 5% to your retirement account and $100 a month into a taxable (ie non retirement) account automatically each month.
Virtually anyone can afford to this.
Ideally you’d be maximizing your retirement account at $19,500 a year (divide by the number of pay checks to figure out what you need to contribute).
Even better, you could be contributing much, much more than $100 a month if you have excess funds after maximizing your retirement and you already have plenty of cash.
When the stock market falls, investing at the new lower level has less risk, not more.
What if the Stock Market Continues to Fall From Coronavirus?
The problem is markets can keep on falling, and it might take 10 years or more for you to make your money back if this is the next Great Depression.
It probably is not.
And even if it was, as a student loan borrower, you have an asset called human capital.
You can earn more money than most people without your specialized set of skills.
As long as your student loan and other debt payments are low and affordable, then you can invest when others might not be able to as much.
That means if we have a severe Coronavirus recession, you’d want to invest as much as you can, provided you don’t need the money for at least 5 years.
The rest of your savings that you’re worried you might need in less than 5 years should go in a savings account.
The Recession Game Plan for Your Finances
Here’s the 5 tips to be recession proof as a student loan borrower:
- Be ready for your income to fall
- Know you might not be able to refinance anything
- Get an emergency fund
- Consider taking action to lower your student loan payment
- Stick to your long term investing plan
Follow these 5 tips and you’ll be way better off than the vast majority of Americans.
And if you really want to be recession ready as a student loan borrower, consider investing in our customized consulting service.
*Editor’s Note: The original version of this article was published in October 2019, but was heavily updated to reflect the spread of COVID-19.
What do you think about what could happen from a Coronavirus recession? Comment below and share your thoughts.