You did it. You graduated from school, you’re working — and now you’re paying off the debt that helped you get that diploma and that job. Well, you’re not alone: Roughly 40 million Americans have student loans, which means that student debt is a big part of many people’s finances.
Now that the Federal Reserve has raised interest rates, the cost of some of that debt may be getting more expensive depending on the type of interest you have on your loans. Therefore, it’s even more important that you understand how to pay them off.
This goes beyond basic debt management, which is simply meeting the minimum monthly payment and paying on time. The idea here is that you tackle your student loans in a way that helps you avoid spending more than you have to on interest and fees. Not to mention the peace of mind that comes with having a fleshed-out repayment plan.
Here’s what you should know to pay down your student debt.
Loan Type Matters
Looking at all of your student debt in one place can be overwhelming, and it’s probably something you’d like to avoid — but it’s worth doing.
Start by finding out which of your loans are federal and which ones come from a private lender, like Sallie Mae. Federal and private loans have different repayment terms, so this can affect the way you decide to pay them off.
Here’s the starkest difference: Federal loans offer a lot more repayment flexibility. Income-driven repayment (which ties your minimum monthly payment to your salary) and loan forgiveness (which eliminates outstanding debt after certain types of public service) are only available for federal loans.
Since private loans give you next to no wiggle room when it comes to repayment, it’s a good idea to focus on paying more than the minimum on these loans first. And to make sure those big payments really are going the extra mile in bringing down your debt, you need to understand the interest rates on each of your loans.
How Student Loan Interest Works
Interest rates on student loans fall in one of two categories: fixed rate or variable rate.
Federal loans issued after July 1, 2006, have fixed interest rates, which means the interest rates on your loans don’t change after you’ve taken them out. In contrast, private loans can have fixed or variable interest rates; the interest rates on variable-rate loans change depending on economic conditions. This helps explain why, though rates vary by lender, some estimates place private loan interest rate averages between 9% and 12% — much higher than the 3% to 7% range for federal loans.
The Fed rate hike is one condition that will affect any variable-rate loans you have. Higher interest rates — and experts expect the Fed to hike them again in 2017 — mean those loans are going to get more expensive.
That’s why your student debt repayment plan of attack should start with paying more than the minimum each month on the private loans with the highest interest rates. This applies even if you have bigger loans at lower rates. That’s because interest costs can add up when interest rates are high, even on a balance of a couple thousand dollars.
Also, remember to keep an eye out for updates from your lenders about changes in your student loan interest rates due to the Fed rate hike(s); you may need to adjust your repayment plan depending on these changes.
Now, About Your Rates
After you figure out the interest rates on your student loans, your next step is deciding if and how you’re going to lower them. You can still do this even if the Fed rate hike raises your rates.
One option — and probably the easiest — is signing up for auto pay, which can shave around 0.25% off of your interest rate on federal Direct Loans and private loans. Certainly not the world’s biggest discount, but it’s nice to save money where possible. Not to mention that you’re less likely to miss that money or be tempted to spend it if it’s automatically deducted from your bank account.
Refinancing is another possibility. With refinancing, a lender replaces your existing private loans with a new loan that offers a lower interest rate. You need to have a good credit score and proof of employment to qualify. When you refinance, you can either get a variable-rate or fixed-rate loan; rates can be as low as a little over 2% for the former or 3% for the latter, though the rate you get ultimately depends on your financial profile.
You can refinance through a traditional bank, or you can go with an online lender that specializes in student loan refinancing services, like Earnest, SoFi, and CommonBond. Typically, there aren’t any fees to apply.
By the way, you may have heard about loan consolidation; this is different from refinancing. Consolidation takes all of your federal or private loans (never both) and packs them into one single loan with an averaged interest rate and one monthly payment.
This probably sounds appealing due to its simplicity, but the truth of consolidation is more complicated. Consolidating loans often means you’ll be paying off your debt for a longer period, so you can end up paying more in interest costs when it’s all said and done. That said, if your credit score has improved by at least 50 points since taking out your private loans, your lender may give you a lower rate if you consolidate. In this case, it can be worth checking out.
Looking Beyond Interest
The federal government doesn’t offer much when it comes to cutting federal student loan rates. Thankfully, you can apply for an income-driven repayment plan for most federal loans. (Private lenders don’t offer them.) This option can be especially helpful if you have a lot of student debt and are overwhelmed by the amount you’re supposed to pay each month.
Income-driven repayment plans use your discretionary income — how much your pre-tax income exceeds the federal poverty line — to determine an affordable monthly payment for you. The repayment period for an income-driven repayment plan lasts 20 or 25 years, depending on the plan, and any outstanding balance at the end of the repayment period will be forgiven.
Presently, the federal government offers four types of income-driven repayment plans. With the REPAYE plan, monthly payments are typically 10% of your discretionary income. The PAYE plan is pretty similar, except your payments can’t exceed what you’d pay under the standard 10-year federal loan repayment plan.
Under the IBR plan, depending on your borrower status when you took out the loan(s), your monthly payments will be either 10% or 15% of your discretionary income (again, never more than the standard 10-year amount). And if you go with the ICR plan, your payment with be either 20% of your discretionary income or what you’d pay with a 12-year repayment plan with fixed payments — whichever is lower.
One final point about your student loans: At Ellevest, it is our view that when the interest rate on your debt is 4% or lower, you should consider investing in the markets, alongside paying off your debt. Why 4%? Because historically, on average, the market has returned more than that annually. People rightfully say education is an investment in your future, but we believe there’s nothing quite like actually investing to help get the future you want.
In a planning mood? See what an investment plan could help you do in “The Power of Planning”
Post by Sylvia Kwan, Ph.D., CFA
Sylvia Kwan is the Chief Investment Officer of Ellevest.
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