Rethinking Our Student Loan Repayment
I logged in to my Sallie Mae account recently – I check in on it 2-3 times per year just to make sure nothing has changed. My remaining loans are subsidized and in deferment so their balances should be completely static until I graduate and they come out of deferment. However, when I logged in this most recent time I noticed that the interest rate on three of my loans had dropped from 3.61% to 1.79% (the fourth is still at 6.8%). I, um, didn’t realize those rates were variable…
Somehow 1.79% feels radically lower than 3.61%. Our plan has been to take the money we have set aside to pay these loans (currently invested in a few vehicles, though without a divestment plan) and pay them off right before I graduate. I used my grace period after undergrad so I don’t get another one after grad school. With this plan, we won’t pay interest on any of these loans. (I had a small unsubsidized loan but I paid it off during the previous grace period.)
I have already decided that if I had a mortgage at today’s rates I would want to pay it off sloooooooowly and invest money instead. Yes, that means paying interest, but we would be likely to come out with a higher net worth. And 1.79% is even lower than that hypothetical mortgage rate that I would milk… So why wouldn’t I make the same decision regarding the student loans at the lower rate? Should we keep the money invested and only pay the minimums on the loans?
What are the differences between mortgage and student loan debt?
- bankruptcy – student loans are not bankruptable but mortgage debt is
- collateral – a house is collateral for a mortgage but student loans are not collateralized
- repayment period – a normal student loan repayment period is 10 years, rather shorter than the 15 to 30 or so for a mortgage
- balance – in typical situations, the debt balance for mortgages is much higher than that for student loans
- forgiveness – if I die (or develop certain disabilities), these federal student loans are forgiven
We are essentially collateralizing the student loan debt with our savings, and obviously if we came close to bankruptcy having paid off the debt would just bring us that much closer.
The only way we can expect to make money by paying back these loans slowly is to garner a higher rate of return with our invested money than we are paying in interest – with a healthy margin in between. Right now since the loans are sitting at 0% all we have to do is not lose money, which has been fairly easy as the US stock market has been going like gangbusters. We have the money invested in a few different vehicles – a good chunk in a CD (at 1.18%), a lot in “low risk” mutual funds (rating 2 at Vanguard), and a little in higher-risk stock ETFs and mutual funds.
If we want to beat 1.79% instead of 0% I would actually want to move to all stock investments – but in this case we would also be extending our timeframe from 3 years to 10 years so higher risk is more acceptable. I’m sure over that time period we would see a rise in interest rates, which means that my loans might reset again to a higher interest rate. If they went up to 6.8%, for instance, we would probably bail out of the idea of beating that rate and cash out and pay the loans off. Of course, if that corresponded to a stock market downturn, we might end up losing money on the whole endeavor. I don’t want to try to anticipate what the market will do.
If we were to attempt this, I would like to have a plan going in of all the various scenarios in the market and interest rates that might play out and what our response would be. We could create our own sort of stop-loss to sell completely if our invested balance dwindles to a certain percentage above what we still owe, but that wouldn’t save us from losing in a very sharp market downturn.
Obviously I’m still thinking through what we might do and no decisions need to be made until I graduate, which is a year away at least. Kyle is a bit more risk-averse than I am so he is still in favor of paying the loans off completely before we pay any interest.
Is there anything important about this scenario that I’ve overlooked? Do you consider student loan debt different from mortgage debt, even if the rates are the same? What would you do if you had student loans at 0, 2, 4, or 8% and the ability to pay them off?
photo from Free Digital Photos
Filed under: choices, debt, investing · Tags: stock market, student loans
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IMO debt is debt. I would strongly consider paying it off and getting it out of your life before ou take on other debt like mortgages, car payments or something else. You will feel much freer without that burden of debt hanging over you.
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The only debt we’re likely to take on in the future is a mortgage. I suppose I would consider a car loan if it was super-low interest, but again only if we have the money to pay for it that we would invest in the meantime.
Maybe it’s the kind of thing you can only feel when you’re on the other side of it, but I really don’t feel a burden because of this debt. We know we can pay it off anytime we want but we are pleased to be making some money off our money in the meantime. Now, if our stocks took a downturn and we could no longer say we could pay it off, that would probably feel bad, and that is a risk.
Considering that you can get a short term investment account at Vanguard that has a long history average of a 7% return, you’re better off investing money you’d pay extra to the low interest subsidized debt. You do need a minimum of $3,000 to open one of those accounts but it seems so much better a return than paying off the low interest debt.
I think we would consolidate all our funds into 1 ETF/mutual fund so we can DCA out easily. I suppose we’d have to sell it all when we got to the fund minimum.
I’m with Kyle on this one. I’m just not comfortable trying to play the interest rate arbitrage game.
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Does that go to a mortgage, too? Because that’s what I’m trying to figure out here. If I am willing to do it for a mortgage, why not this debt, too?
I wouldn’t for any kind of debt. I’d personally focus first on paying off any debts I had before I worked on wealth building.
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I hope you get through yours soon, then!
I completely understand where you are coming from because you want to take advantage of the best scenario for your finances. I tend to do the same, but then I think about the risk associated with debt. Also peace of mind with being debt free is liberating. Homeowners need a good surplus of money every month because things tend to break and with a bigger house expenses tend to rise.
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What do you think your break point is for accounting for risk? 2%? 4%? How big of a spread do you need between the interest rate and long-term return before you think it’s worth the risk?
I guess I would vote for getting rid of the debt at this point. It is going to earn you better then any “safe” investment at this point, and will just put you in a better position for other things you want to do.
Well, we’d move to more risky investments if we decide to keep this 1.79% debt around. But we’ll likely just pay it off – I’m just trying to think about how this situation is different from that of a mortgage.
you have listed some of the differences. But a non asset backed loan or a loan on a non appreciating asset should definitly be paid off first over a home loan that is on an appreciating asset. A home loan itself is a form of leverage on an investment. A student loan or car loan is not.
Why do you think debt on an appreciating asset is more acceptable than on a depreciating/neutral?
I played the strategic deferment game a little, but it’s one that you need to be really careful about because I did get bit. AES started my deferment in May, though I didn’t graduate until August… So 6 months after August I went to make my first payment and was told I was 60 days past due. I hadn’t received any notifications of this. I immediately caught up and accelerate payments, and the loans have been paid off since 2008, but that hit is still going to be on my (orherwise perfect) credit report through next February.
I tried to contest it since they had my grad date recorded incorrectly but was never able to fix it.
I guess what I’m saying is be careful. There are real benefits, but real risks too!
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We’re already well into the strategic deferment thing – now we’re talking about leverage! Thanks for letting me know your cautionary tale. That’s awful that you didn’t receive any notifications and it was their mistake on the date. Right now my loans are deferred until 2015 but I will definitely check more often as we lead up to my graduation date. If we pay it off before it comes due we’ll be sure to do it a month or so before I defend. I messed up with my first grace period a bit and Sallie Mae is unrelenting!
Since Leslie and I are 100% focused on paying off debt, we would probably choose to pay off the student loans regardless of the interest rate. Not having to worry about potential interest hikes, or paying for emergencies is a big deal to us.
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The interest rate hike is a very good point. I think it’s very likely that it will reset to a higher rate before we’re finished paying off the loans at the normal pace! It might even be quite soon. I should investigate more how the rates are determined and how much lead time we might have.
At that low of an interest rate currently, the math clearly says to invest rather than to pay off the loan on a 10 year timeframe. With $16k owed & some amount more than that invested, I think the numbers are manageable enough to justify the risk. Even a worst case scenario can’t be all that bad: it’s not like you’re going to suffer 100% losses. I’d say the biggest benefit will be getting to see your risk tolerances and your stop-loss plan in action.
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It would be good practice to create a plan and see if we can carry it out. I’m not sure when else we’ll be doing medium-term investing, though – house downpayment? kids’ college? My idea is sort of to carry our profits forward into a house downpayment…
I’m definitely in the ‘anti-debt’ camp too. Student debt in Australia is pretty different (I explain it here http://wp.me/p30yk2-ev) and I know a lot of people who just let it naturally get paid off with payroll deductions. That being said, I wouldn’t have wanted to have a mortgage without paying off those debts first. And as to a car, I don’t think I’d buy with a car loan, ever. There’s always old cars and if I can’t save $2k for one, then perhaps I can’t afford a car and it’s running costs!
But you mention that you have an interest free period? If it were me, I might wait til that ends, and then sling a stack of cashola at the loan? I know you’re ‘earning’ more on the investments, but I just like debt to be gone!
As to paying the mortgage off slowly – I took a ‘slow’ approach this first two years with a fixed loan (fixed repayments too with only $5k extra permitted). Going forward from the Dec rollover, I think I’ll continue to over contribute, maybe by more than the previous two years of $5k. The more I pay down on the mortgage, the more I have when I sell and buy again. At the same time, I’ll trickle more money into shares, just to be a little diversified.
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We’re already pretty committed to waiting until the subsidized deferment (no interest accruing, no payments due) period ends. The loans have been in that state for 5 years already! Paying all of them off right before they start accruing interest/come due has been the plan for some time, but that was when the interest rates were higher.
What’s the interest rate on your mortgage? I think if the rate were low enough we’d be committed to the slow payoff like you were unless we were underwater and wanted to sell or refinance or something. I agree with you though that paying it down isn’t a bad option at all.
I have a 5.94% rate, which was incredibly low in Dec 2011, but now there’s lower. I’ll definitely look for something more competitive this Dec when it’s up for changing. See, if you chose variable interest, you risk the rate rise, and paying more to pay it off.
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I hope the low rates stick around long enough for you to take advantage!
The only way it makes sense to invest over paying off low rate debt it if you actually stick with investing the money over a long time horizon. What I mean is this: many people avoid paying off debt to invest but then somehow the money never gets to the investment. They find something else to use that money on. Secondly, the stock market is volatile over the short term. If you were planning on investing this money for 20 years or so, I would say go for it. If it’s just five years, I’d have serious hesitations. In just the past 5 years the market returned close to 150%. What if that were the other way around?
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You make a very good point and the other one to add to it is the variable interest rate. The interest rate spiking could reduce the payoff period from 10 years to only a couple, and then it really wouldn’t make sense to keep the money invested.
Emily, that’s a fascinating idea. I think about this sometimes when I consider what a mortgage would do to my asset allocation. I say invest it in higher risk index funds until the interest rate hits 4%. At that point you will have already gotten a deal, so then you can worry about paying the loans.
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How do you come to 4%, though? I have heard there is math to incorporate risk into these types of evaluations but I don’t know what it is!
#2 has a post percolating about this– she recently paid off her lower-than-mortgage-rate interest student loans. Why? Because her loans got sold and Mohela was a PITA to work with, and each month it was a hassle. So the aggravation factor alone was worth it to her to get rid of them.
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I definitely can see that the hassle factor would tip the decision the other way.
(1) Pay off the loan: When qualifying for a mortgage, your application will include your income/debt ratio. Regardless of your ability to pay it off at any time with a lump from savings, debt will hurt your ability to qualify for the best rate possible. (I think)
(2) Don’t pay off the loan: Liquidity. Depending on your current non-IRA investments and cash reserves, how much do you expect to need for down-payment on your first home? How much liquid $ does that leave you on-hand for living and emergencies? Once you pay off that loan, the cash is gone forever.
Both very valid points. I don’t think our debt-to-income ratio, once we decide to buy, will be any problem for our interest rate. But if it were I would pay off the debt right then during pre-approval. Likewise, $16k or whatever it grows/shrinks to is going to be fairly small in comparison with a down payment if we end up living in San Diego. As far as the rest of our cash goes, we have structured everything so that we never touch this savings. We don’t account for it or think about it when we think about our cash on hand, although if it came down to it came down to it we would use it in an true emergency. So again for us this comes back to potential earnings and risk.
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Can you lock in that 1.79% or can it vary in the other direction, too?
I’m not certain but I think it would be apt to increase! That’s the biggest pitfall I can see to keeping the debt.
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