HOW TO PAY OFF STUDENT LOANS

If you have been following this series of blog posts, you know that college funding is the focus. The process, while easy on the surface, requires three steps. First, save for the cost of college. Many sources – from bloggers to financial publications – discuss this topic, and large financial institutions tell you how to save for college. The second step, shopping for colleges, has been the focus of the last two blog posts, which reviewed trends in college funding and how to pay using the different types of student loans. We continue with the second step of the discussion: paying back student loans. The last step will help you save on the cost of college.

First Student Loan Conversation

As a Certified Financial Planner, I was not aware that dealing with student loans would become a common planning topic in the same way that planners now help Boomers with Social Security planning. I became aware of this need only a few years ago. In 2010, I had my first conversation that shaped the way I see this crisis.

The son of a client came into my office with his new bride to talk about cash flow and getting his new life off to a great start. We talked about many of the normal things young couples desire: a nice home with a family, vacations, and cars. There were miles of smiles around the table as the conversation progressed.

Then I asked about income and jobs so that we could focus on making these dreams a reality. The conversation quickly came to a halt. The wife had just begun her first job and had a student loan that was large but workable. The husband sat quietly in his chair while the wife and I discussed the details of her income, student loans, and job. Noticing that he was uncomfortable, I asked the husband what was on his mind. He revealed that his student loan debt totaled just over $100,000. He did not work and was not confident that his liberal arts degree would allow for the lifestyle we had discussed.

This conversation drew my attention to the effect student loans can have on a young person’s life. Unfortunately, my professional life took me in another direction. I did not return to this negative reality until six years later, when we started college planning for my oldest daughter. This brings us to the important question.

What is the best strategy to pay back student loans?

Google the term “strategies to pay back student loans” and a plethora of articles will pop up discussing everything from making more than your minimum payments to refinancing your loans to taking on a job that provides forgiveness. While these methods have worked for some people, I subscribe to the keep-it-simple mentality.

Two strategies have proven successful among families that face a large amount of debt. Dave Ramsey created one of the popular strategies, called the Debt Snowball. This is by far my favorite strategy because it acknowledges the power of behavior. The strategy is simple.

  1. List all your debts on a piece of paper, from the lowest dollar amount at the top to the highest dollar amount at the bottom.
  2. Write out the minimum payment next to the loan balance.
  3. Make the minimum payment on all the debts except for the one with the lowest balance.
  4. Pay as much as you possibly can toward the lowest-balance debt. Before you know it, the debt will be gone.
  5. Scratch the debt off your list and start over. Make the minimum payments on all the debt except for the new one with the lowest balance. Again, pay aggressively on this balance until it is gone.

With this strategy, momentum builds quickly because of the quick victory in paying off a few of the lower balances. The student loan borrower will see that getting out of debt is possible and will not feel as overwhelmed. The downside is that this is not the optimal strategy financially. You may pay more interest because the highest-interest loan may not have the lowest balance. In my opinion, though, through the creation of a momentum-building sequence, the debt holder will stick with the strategy, thereby yielding better results.

Interest Optimization

The second strategy takes a similar approach but instead of listing the loans by balance, you list them by interest rate, with the highest on top. As with the Debt Snowball, you make the minimum payments on all loans with lower rates and pay aggressively on the high-interest rate. While this creates an optimal financial outcome, the average debt holder has a hard time creating momentum. The strategy is best suited for those who easily understand how debt and compounding work.

The other strategies that you would see in a Google search typically involve one-off actions like refinancing. You may lower your interest rate, but did you extend the term of the loan or give up other provisions by moving away from federal loans? Taking a job that provides forgiveness may translate to lower take-home pay. Think about the difference in pay when working for the government or a company.

Spending Plan

You may have noticed that both strategies require “paying aggressively” toward one of the loans. This means creating margin in your monthly cash flow. How do you do this? First, you avoid using the word “budget.” This word interrupts financial progress. People associate budgets with micromanaging and doing without.

Creating a spending plan means balancing those things that are most important to you while creating the margin to put toward your student loan debt. You do not have to focus on where every dollar goes; rather, consider whether each purchase creates the highest level of happiness for you or your family.

Two methods can be used to create my favorite style of spending plan. The simple versus may be completed using four different-colored highlighters and your bank statement. The second method requires more effort or a spreadsheet. For purposes of the conversation today, the simple version will be the focus.

Simple Spending Plan Instructions

First, pull out your bank statement and use four highlighters, each for a different category: highly important, moderately important, could do without, and savings. Next, decide what goes into each bucket. Third, total the amounts for each category. Fourth, figure the percent of total spending for each category.

The goal is to create margin in your financial life. Savings should account for 12-30% of your income, while highly important and moderately important should account for the rest of your spending. If, for example, you encounter a lack of savings, you must prioritize your spending so that the lower, can-do-without expenditures can be moved to the savings category. For example, is living in your current place important to you, or is it the features/characteristics that you like? If the latter is the case, find a cheaper way to get those features and characteristics. The goal is to start looking at your spending in ways that promote the important facets of your life. Work with the number until you meet the 15-30% threshold. Slowly work on getting the can-do-without cash flows off your bank statement, then move the cash flow into a savings vehicle that starts increasing your savings bucket. Once you have the cash flow straight, a small amount of savings will likely have accumulated; you can use this to pay down student loan debt or, more importantly, act as an emergency fund. Now you will move the cash flow that built your savings to aggressively pay down the debt.

Student Loan Refinancing

Having followed the exercises above, you have created a margin in your monthly cash flow and know which debts to aggressively pay down first. Next may come the question of whether you should refinance or restructure your student loans. Exercise caution when addressing this topic and consider the following points.

– Beware of income-based repayment plans and their true long-term cost. You are trading dollars today and tomorrow for much later.

– If your plan is to simply find a job after school, you could be missing out on opportunities for student loan forgiveness. This may change, but states also offer student loan forgiveness programs. Reference the other article I have already written.

– When consolidating federal loans into a private loan, you may be giving up the following: income-based repayment options, access to student loan forgiveness programs, and forbearance and deferment options.

Wrap-Up

A payback strategy is great; start small and work on building momentum. Use the technique above to build your emergency fund. Once you check off these two items, you can address the next common hurdle that many parents face.

Should parents of teenagers save for college or retirement? Even younger millennials try to answer this question with their young children. Keep an eye out for the next article, which examines this dilemma.