No, seriously. I'm asking. Anyone have ideas?
Let us say "hypothetically" you've just received your graduate degree. And that you now have around $65,000 in federal student loans, work for a start-up, and intend not to die young.
Should... "you"... go with income-based repayment, graduated repayment, or standard repayment? Should you try to cut down on the debt if you receive a windfall? Should you be paying down an extra $10, $50, or $100 a month if you can afford it?
These are only easy decisions if you can either comfortably afford to pre-pay your entire debt or if you have no choice but to go on income-based repayment to scrape by. But for those of us in between, it is likely the most important investment decision we face right now. The "right" decision depends very much on your personal profile.
It's easy to say that it depends, but quite another thing to decide what it depends on. In order to get there, I'd like to frame the issue as a tension between two perfectly reasonable positions.
- Perfectly Reasonable Position #1: I should pay as much as I can every month in order to cut into my principal, minimize the amount I pay over the life of the loan, and maximize my long-term savings. I cannot save at a better rate than my student loan rates and therefore this is the best use of my money in the long run.
- Perfectly Reasonable Position #2: I should pay a minimal amount now. I just received a professional degree and have started a job with a modest salary. I anticipate that in 5 years I'll be making significantly more money than I am now. Money is more valuable to me today than any extra money saved on student loan payments in the future.
While these are extremes, I still maintain that they're perfectly reasonable. And that is what makes deciding how to proceed on this question such a difficult decision.
Reading articles on student loans is a part of my job, so I've absorbed a great deal of literature on this subject. But not one thing I've read hits this question head-on. Most articles outline the options you have and offer no advice on choosing between them. While I do not pretend to be an expert, I do think it might be valuable to share how I approached my student loan debt.
To sort through the extremes represented by PRP #1 and PRP #2, I considered what I should do along three dimensions:
Saving for Emergencies Now
You cannot repair a broken windshield by screaming "I DID THE RIGHT THING WITH MY MONEY BY ELIMINATING A CHUNK OF STUDENT LOAN PRINCIPAL" at it. Life has all sorts of little surprises waiting for us. And if you're eliminating potential savings with more aggressive loan payments, then you'll be spending even more on overdraft fees when you encounter these bumps in the road. And that buffer savings isn't for you to boondoggle away on your dream of becoming a professional poker player; it's for a rainy day. Learn to build and protect it and then focus on paying down the principal of your loans.
Full disclosure, I'm still trying to figure out an appropriate buffer savings number for my own comfort, but I am adding a small amount to my savings every month and feel more comfortable that I have a growing buffer in case of emergencies. I suggest you take a step back and look into how to build small short-term savings instead of just paying your loans, paying your bills, and feeding the cats. Even small amounts can add up over time and make you more secure in case of the unexpected.
Saving for Big Expenses Later
Do you want to buy a car? Maybe purchase a house? Perhaps retire someday? Well, once you've built up enough savings for emergencies, you can think about how quickly you want that new house. And if you want it fast, then maybe you pay off those student loans a little faster. Now that you're receiving an income, I would argue that you should start working towards your long term financial goals rather than thinking they'd be nice someday.
"But wait... Nate... aren't you going to be a startup bazillionaire?!"
Well, the uncertainties of #startuplife dictate that I not allocate a piece of my budget to "buy a house" just yet. However, I can see a scenario in the near future where I'm paying my student loans at a greater-than-standard-repayment clip. And then, as my monthly payment is lowered, I allocate those leftover funds to saving for long-term expenses. This is how I intend to approach this so that I'm keeping a constant "savings flow," attacking my principal to lower interest costs, and saving to buy a house.
Where Will I Be in Five Years?
I know it's easy to view your current salary as your only real asset. But there's this other thing... you. For our purposes we'll call it "human capital" and define it as the quality of the years that you will contribute to the workforce (though there are various definitions). However you want to look at it, I doubt I'm sparking much controversy when I say that the next 20 years of your financial life must consider your human capital. After all, you've just invested in one of the most tangible measures of human capital growth in our society: the academic degree. So what does this all mean for how you should approach paying student loans? The basic idea is that you'll be acquiring human capital as you work. Remember all those job postings that required 2-5 or 5-10 years of experience? Well you won't hate seeing them so much in 2-10 years. That's because you've (hopefully) developed human capital in the form of job experience and this should translate into a higher salary in the future. Therefore, the thinking goes, you can afford to pay less now because your earning capacity will be greater in five years. With lower payments you can put something towards savings, a purchase like a car, or maybe even *gasp* a little fun.
This is probably one of the most personalized factors to consider. There is significant variance between where a particular person thinks they'll be in five years and how much they're willing to bank on it. As a newly-minted attorney working for a startup I have reason to believe that my human capital will only grow in the form of legal and business experience, personal and professional connections, and being able to display a diverse skill-set. But for those of you keeping score at home, you've probably noticed that I'm not the type of person who wants to count on that. So I basically split the difference when it comes to thinking about my human capital and student loans. By splitting the difference I mean that I'm not paying off my loans aggressively, but I'm not on income-based repayment either. I'm making regular, standard repayments. I strongly considered going on IBR (because I could be), but ultimately felt that I should make the better long-term choice since I was on the fence. I prefer to err on the side of caution.
Let's Apply What We Know.
Imagine you have six-figures of student loan debt and suddenly come into $15,000. Do you pay it all down? Do you keep that as your buffer? Do you spend it all because life is short and not about student loan debt?
I hope that I've convinced you by now that there are more factors to consider than just paying off your loan as quickly as possible. Every student loan borrower is working towards a more productive future, but you should recognize that your finances are about more than maximizing savings at all times.
The $15,000 windfall I mention above actually happened to a friend of a friend. And she put all the money towards her six-figure student loan debt. The result? She has to make roughly the same monthly payment for 10 years and does not have access to $15,000. This may not be a bad thing if she can reasonably afford her payments, but she paid down the debt without fully thinking through her options AND with the expectation that she'd be paying significantly less per month. The point is to thoughtfully consider where you are financially, what your goals are, and what your earning capacity will be over time. A windfall doesn't change the need to consider these factors.
Here's How I Approach Windfalls:
Step 1: Demand Fate bestow $15,000 upon me without my having to work for it.
Step 2: Thank lucky stars and recklessly burn through $2,000 while screaming "YOLO" to the annoyance of everyone else.
Step 3: Wake up to much shame and regret and quickly throw $3,000 into buffer savings and pay down $10,000 in student loan debt.
Step 4: Repeat.
This is my five-year plan for paying off my student loans.
In the final analysis, I believe you should maximize your monthly payments relative to your conditions now and your long-term goals. In my case, I have around $65,000 in student loan debt and feel that I should enjoy my youth. However, I'd still like to be a home-owner within the next ten years.
So how aggressively should you pay off your student loans? Well, it isn't something you can pull from a repayment calculator. But I hope you have a better idea of what it depends on for you.
Nate Howard is Community Curator at CommonBond, a social lending platform that connects student borrowers and alumni investors to lower the cost of education for students and improve financial returns for investors. CommonBond is also the first company to bring the "one-for-one" model to education.