Claire is a 28-year-old graphic designer based in Boston. Up until now, she hasn’t put much thought into her student loans, aside from paying the bills religiously (about $120 per month). Most of her friends are in a similar situation, so it doesn’t seem like a big deal. However, she recently got a new job for a large corporation that pays significantly more than the boutique firm where she used to work. Should she put the extra money toward paying down her debt? Or should she contribute it to a retirement account instead? Is there anything else she should be doing about her loans that would be more strategic, in terms of her future financial security?
Millennials: We’re a generation in debt. In 2012, a study showed that 71 percent of all graduates from four-year colleges were marching into adulthood with a negative net worth ($29,400, on average). It’s a wildly imperfect system, but here we are. Claire, congratulations on taking this in stride, staying on top of your loan payments, and landing this great new job. You’re doing exactly what student loans were designed for: using your degree to build a career that will pay for your education, and then some.
In an ideal world, you’ll ignore your fat new paychecks and keep your current standard of living just the way it is. Pretend you’re still making what you used to make, if you can. (Maybe treat yourself to one cool trip — you deserve it, and it’ll help you live longer. Then get back to work.) Instead of absorbing the extra dollars into your day-to-day living — which will be very easy to do, believe me — set it aside and consider the following questions.
What’s the interest rate on your student loans?
If you’ve taken a head-in-the-sand approach to your debt until now, it’s time to get acquainted with the particulars. “I’ve found that most people don’t have a basic understanding of their loans,” says Kristin O’Keeffe Merrick, a financial advisor at Raymond James. “Spend some time getting to know them. How much do you owe in principal, and how long will it take to pay it off at your current schedule? Knowing your exact interest rate (or some kind of weighted average, if you have multiple loans) allows you to make better decisions.”
One of those decisions is whether to increase your monthly payments, now that you can afford to, or put that extra cash toward retirement instead.
“If your rate is 6 percent or lower, you should absolutely be contributing to a retirement plan,” says Merrick. (Most student-loan interest rates fall somewhere between 4 and 8 percent.) The logic behind this has to do with return rates — the percentage of your “investment” that you stand to gain in the long run. Any time you shovel money toward debt, your return is equal to its interest rate, because that’s money you won’t owe later. Compare that rate to the average return on a 401(k) portfolio — which most financial experts place around 7 percent, currently — and see which figure is higher. If one money horse is running faster than the other, put more behind it.
For example: “If your student loan interest rate is 4 percent, but the average annual return on your investments is 7 percent, then you’re making more in the long run by investing in the market,” says Merrick. “However, if the interest rate on your loans is anywhere near the return rate on your investments — say, close to 7 or 8 percent — it makes less sense to start investing for retirement before you pay off your student debt.”
Also, what’s the deal with your 401(k) program?
There’s one exception to the above rule, and that’s if your employer offers a 401(k) match. “In that case, you should be making contributions to your 401(k) at the expense of paying down debt faster,” says Merrick. Matching programs are often referred to as “free money,” and you’ll want to take full advantage. Back to the return-rate discussion: a dollar-for-dollar match is a guaranteed 100 percent return — obviously a much more desirable option than the piddly single-digit interest rate on your debt.
In a perfect world, you’d multitask — get all your 401(k)-matching money and raise your monthly debt payments at the same time. Do this if you can.
Do you want to refinance your loan?
“You should at least look into the refinancing your student loans if you have never done so,” says Merrick. A good payment record and decent credit score might give you a chance to lower your interest rate. And for the sake of your own sanity, you might also want to consolidate multiple loans, or release any co-signers (like your parents) from the arrangement. Be aware, though: If you refinance a federal student loan, you stand to lose cushy benefits like income-driven repayment plans (if, heaven forbid, something were to happen to your shiny new job) and debt forgiveness (in case of more grim circumstances).
Also, know that refinancing doesn’t change the size of your debt. “It is essential to understand that when you adjust the repayment terms of your student loans, you are not reducing the total loan amount outstanding,” says Manisha Thakor, the director of wealth strategies for women at Buckingham Strategic Wealth and the BAM Alliance. If you can wrangle a lower interest rate, however, then it’ll cost you less over time.
What else do you want to do with your money?
Do you dream of buying a house or an apartment in the near future? You don’t have to be debt-free to do so, by any means, but you’ll get a much better mortgage rate if you have a low debt-to-income ratio (DTI), explains Thakor. “To determine if you’re eligible for the best mortgage rates, many lenders follow the 28/36 qualifying ratio,” she says. This sounds technical, but it’s actually very straightforward: Even with the addition of a mortgage, you’ll be spending no more than 28 percent of your gross monthly income on total housing expenses, and no more than 36 percent on all debts (including student loans and said mortgage).
Of course, you can still buy a home with higher numbers, but your mortgage rates will be higher in turn. Same goes for most other types of loans. “Outstanding student-loan debt can hurt you, absolutely,” says Thakor. “Lenders don’t want to loan money to you if you have too much existing debt, because they worry you’ll have trouble paying off their loan.”
That being said, as long as your payment schedule is under control, student loans are a far cry from “bad” debt like outstanding credit-card bills — don’t lump them together. Besides the fact that they helped you afford an education that increases your earning potential, they can also help you build good credit, which is a nice perk for your overall financial health. As one of my friends put it, “It’s the best debt you’ll ever have.”