Thinking about student loan strategy and consequences before entering repayment is a great way to get a head start on student debt. The little steps and small payments made during school can have lasting benefits.
While there is no single ideal strategy, there are a number of approaches that students can use to get a leg up on student loan repayment. Each one has pros and cons, but any of the following represent a much better choice than simply waiting until the first student loan bills show up in the mailbox.
Make Interest Only Payments During School
We often suggest this route to parents who are concerned that their children may be getting in over their head.
The advantage of this in-school repayment plan is that it is a monthly reminder of the consequences of student loan debt. For a freshman in college, the interest on their loans may not seem large. As time progresses, balances grown and interest only payments go up, the reality of life with student loans becomes very clear. This will encourage responsible borrowing and be motivating when it comes time to find a job after school.
Another perk is that upon graduation the amount that must be repaid is equal to the amount borrowed. For students who do not make payments, their balance at graduation is significantly larger than what they borrowed due to interest.
Pay Down the Highest Interest Rate Loan
From an accounting standpoint, this is the most efficiency use of money earned during school. Eliminating the student loan with the highest interest rate will make each dollar go as far as possible.
While the math would suggest this approach, it is important to consider other options that may ultimately be more beneficial.
Attack Private Loans First
It may come as a surprise to student loan borrowers who are still in school, but dealing with federal student loans after graduation is much easier than private loans. This is especially true for graduates who have a tough time finding a job or end up making less than they anticipated.
Federal loans come with important borrower protections such as income-driven repayment plans and forgiveness programs like Public Service Loan Forgiveness. Having these perks available is a huge asset to borrowers with an uncertain future.
For this reason, eliminating private student loans first can be a smart strategy in the long run.
Try to Eliminate a Loan Completely
Suppose you have a job with a good income for the summer between your junior and senior year. Paying down student loans is a great way to spend this money.
With a fixed amount that is fairly easy to project, it might make sense to use the money to pay off a loan entirely. Better yet, if the funds can eliminate one lender completely, this strategy becomes even more advantageous.
The idea is that by paying off a loan in full or eliminating a lender, you are eliminating one bill to contend with after graduation. This means one less headache, and one less chance for bookkeeping errors.
Pay Down Variable Rate Loans First
Suppose you have two loans: one at 4.5% and one at 5.5%. On the surface, paying down the 5.5% loan first may seem like the obvious choice. However, if the 5.5% loan is a fixed-rate loan and the 4.5% loan is a variable rate loan, the decision isn’t as simple.
Interest rates on variable-rate loans can increase significantly over time. While some of these loans are capped at 8-10%, many can have interest rates that grow even higher. Suddenly, the 5.5% loan is the cheap one.
The question comes down to a gamble on the future of the economy and interest rates. For borrowers who expect to pay off their loans quickly after graduation, the variable-rate loan represents much less of a risk. Those who take many years to pay down their student loans are much more vulnerable to the dangers of increasing interest rates.
Free Your Cosigners
If you have a loan cosigned by a family member or close friend, paying down that loan first should be given extra preference.
Even if you never miss a payment, the loan will show up on the credit report of your cosigner until it is paid off in full. This can impact their ability to get an auto loan or a mortgage. They have taken a risk cosigning a loan and the best way to say ‘thank you’ is to prioritize paying off the debt on their credit report.
After School: Look into Refinancing
As a student you have no job or limited income and no degree. This makes students a risk to lenders. Risky borrowers get higher interest rates.
Graduates — hopefully — have a degree and a job and represent much less risk to any lender. It is for this reason that refinancing student loans after graduation is such a popular move. The refinance company pays off old student loans in full and then the borrower repays the debt to the refinance company at a lower interest rate. Many lenders offer this service and it can be a great way to get lower interest rates after graduation.
The danger is that these private lenders do not offer the same borrower protections as federal loans. For this reason, the refinancing option should be carefully considered before making any commitments.
During school is the best time to start paying down student loans and thinking about repayment strategy.
It may seem like not much can be done, but taking advantage of any opportunity to pay down student debt is a smart move. Sacrifices made during school will help ensure that life as a graduate is more enjoyable and less stressful.