Paying off student loans is an uphill battle.
Interest rates work against you and loan servicers frustrate the process. Making things even more complicated is the fact that we do not pay off student loans in a vacuum. Life goes on during repayment. There are other expenses and far-off dreams like retirement.
Today we will discuss a strategy to eliminate debt and build wealth in the most efficient manner possible.
Financial Priorities: More Than Just Student Loans
The first step in crafting a plan is identifying your financial priorities. If the goal is to build wealth, cuts will have to be made.
The following list should help identify the things that are most important from a financial perspective.
Essentials – Before we even think about student loan bills or saving for retirement there are certain basic essentials that must first be addressed. We have to make sure that the basic necessities, like food and shelter, are addressed. The exact nature of these essentials may vary from person to person, but we all have them.
Minimum Payments – Once you meet your essential obligations, the next step is to meet your minimum obligation on your debt. It should be noted that paying the minimum and just paying the monthly bill are two different things. For this step, you need to reach out to all of your loan servicers to make sure your payment is as low as possible. Even if you can afford to pay more on a given loan, by lowering the minimum payment your can more efficiently use your funds. For example, if you lower the minimum payment on your low-interest student loans, it allows you to pay more towards your high-interest student loans. This saves you money in the long run.
Retirement Match – Retirement matching shows up high on our list of priorities because it is free money. If your employer matches every dollar you put towards your retirement, you want to take full advantage of this program. Most businesses have a cap on the matching, so you will probably want to max it out.
High-interest debt and student loans – The next item on the agenda is high-interest debt, including some student loans. A ballpark figure would be debts where the interest rate is above 10%. Some student loans fall into this category and most credit card debt falls in this category. You are being ripped off by this high-interest debt and the best way to address it is to eliminate it as soon as possible. Start by attacking the highest interest loan first, then go one by one, as you attack the high-interest debt. One potential shortcut here is to find low-interest loans to pay it off. A number of companies will refinance student loans with rates starting in the 2% range. Elimination of the debt will have an immediate impact on your monthly finances.
401(k) and other tax advantaged plans – Using a 401(k) plan is a huge start to getting interest to work for you rather than against you. The tax advantaged plans are especially valuable because the money that goes into the accounts is not taxed until it is pulled out many years from now. Not only does this lower your taxes, but if you are on an income-driven federal repayment plan, it lowers your AGI which means lower minimum payments on your federal loans. It should be noted that not all 401(k) plans are created equal, so it is important to make sure you are not being charged high management fees or dealing with huge expense ratios.
Medium interest student loans and debt – What defines a “medium” interest rate is one of personal preference. Basically, this is the debt that you want to pay off in full rather than just investing the money. Paying off debt should be treated as getting a guaranteed rate of return on your investment. If you have a student loan with 6% interest, would you rather just pay down the debt, or invest it to try to generate a greater than 6% return? If your investment return is 8%, you come out ahead by investing and just paying the minimum towards your debt. However if your investment only earns a 4% return, you are losing money. If you don’t think your investment will outperform the interest rate on your loan, pay off the loan first.
Investment – Next we come to investments beyond a 401(k). This is obviously a huge subject, but one of the easiest and most universally approved ways of investing would be simple index funds. Rather than investing in one stock, you invest in the entire stock market. Going this route doesn’t require a money manager and can be done with almost no expertise.
Low-Interest Debt – The last item on the agenda is the low-interest student loans and debt. If you have a car loan with 1% interest, there is almost no urgency to pay off the loan with any urgency. You could get a savings bond with a guaranteed return greater than the 1% interest rate. In this circumstance, any extra money you have would be better used as an investment rather than applied towards the debt. The one exception to this rule would be if you are trying to buy a home and need to eliminate debt for purpose of improving your debt-to-income ratio.
Wealth Building Concerns
Business Investment – If you want to start your own business and are saving to do so, only you know where that should fall on this list of priorities. This will depend on your willingness to accept risk and your confidence in your business.
Home Down Payment – Saving a down payment for a home is obviously a huge financial undertaking and something that will shift your priorities. If you are looking to buy a home, you need to focus on getting your credit score up, saving the down payment, and improving your debt to income ratio. This can alter which loan gets paid off first and when you start saving for retirement.
Emergency Fund – A key part of any financial planning is setting aside a fund for emergencies. How much you save and where it falls on your list of priorities will depend upon things like family resources available and whether or not you have children who count on you.
Student Loan Forgiveness – If you have a student loan that will qualify for forgiveness under a program like Public Service Student Loan Forgiveness, this loan should fall way down the list of priorities. However, you should run the math on your planning before jumping to any conclusions. You don’t want to spend extra money chasing forgiveness. Many people may find that they save more money by just paying the loan off in full rather than paying the minimum, running up interest, and hoping for forgiveness years down the road.
Other Big Expenses
These would include material desires like a new car, life experiences like travel, and having children. Life is not about running up the score on your bank account. Whether it be having a child or a trip to Paris, our dreams also cost money. Realizing our dreams must be a part of our financial planning.
These goals and desires are different for everyone and do not fit neatly into a list of financial priorities. We suggest using these goals as incentives along the way. For example, once you pay off your high-interest student loans, you take that trip you have wanted to for years. In our article on the Door of Student Loan Debt, we saw how one couple managed their student loans and scheduled everything from Lasik surgery to having children. Instead of just looking at these goals as expenses in the way of getting rid of debt, treat them as milestones to provide motivation in your journey.
There are a lot of moving parts to this equation and many decisions are based upon personal preferences and goals. The key is to understand how these issues all fit together. Talk things out with your loved ones, research, and be willing to revisit the ideas and issues as things change over the years.