Student Loans vs. Investing/Saving with a Twist

November 22, 2009 1:11 PM

The paying back student loan vs. investing/saving question - but with a bit of a twist

So, I graduated from college back in May, building up approximately $40k in private student loans from Sallie Mae. (Yes, I know; private loans are not the best choice, but I've become much better educated in personal finance now and more wary etc.)

However, thanks to good credit, my interest rate is pretty low (based off the Prime Rate and right now <3%). Nevertheless - it is a variable interest rate, and I imagine it will begin to rise in the somewhat near future.

Since my graduation, I've worked in a part-time job with good pay, and have found a very good full-time position I'm starting next month. Take home will be ~$2k/month, and I live in a very low-cost area.

I've already budgeted dedicating $500/month to paying off my student loan (minimum monthly payment about $270 right now, my grace period just ended).

I know people such as Suze Orman advocate not worrying about paying a whole lot more beyond the minimum when interest rate is low, but since my loan has a variable interest rate, I want to pay down enough before the interest rate becomes more sizable. At the same time, I'm investing in a Roth IRA and building an emergency fund, so I want to allocate sufficient funds there, as well.

My question: What would you do if you were in my shoes? Is $500/month reasonable? I'm not well versed in economics, so I'm not sure how easy it is to predict the Prime Rate's future (I've checked out a couple of forecast sites, but not sure how trustworthy they are)-- is there a certain percentage rate where I should start to look at finding a loan from a bank/credit union to move my student loans into at a fixed rate?

Other details: currently I am funding my Roth IRA at $100 every other week, which hits about half of the maximum limit for the year (but I would like to max it out once my full-time job starts). By the end of the year, I should have about $1,000 in my emergency fund. Also, I just don't like being in debt, and am motivated to pay my student loans off quickly, but reasonably.

Thanks so much in advance! I've been lurking on here for a while and thought some people here might have good guidance for an approach :)

posted by 1901gunner to work & money (10 comments total)

I think Suze Orman is generally rather foolish. I would pay that debt off as soon as possible, especially because, as you note, the interest rate is variable and you have no way, bar sitting in on a Fed meeting, how interest rates will move over the next several years.

I would not fund retirement accounts until after your debts are settled.
posted by dfriedman at 1:14 PM on November 22, 2009

Sounds like a great plan to me. You're aggressively paying down debt while slowly building for the future. As the debt goes, you can switch the balance in the other direction.
posted by dirtynumbangelboy at 1:33 PM on November 22, 2009

How certain are you that you can leave all the money in your IRA alone until retirement? If you can leave it alone, any money you put in your IRA now will continue to compound long after your student loans are all paid off, which should have a much larger effect on your payoff than any fluctuations in interest rates over the loan period.

On the other hand, if you think there's a significant chance that you might tap out your IRA before retirement (to make a down payment on a house, say, or get you through a period of unemployment), then I would say your money now will be better spent on paying off as much of your student loan as possible.
posted by strangely stunted trees at 1:35 PM on November 22, 2009

Let me preface this by echoing dirtynumbangelboy's comment above... you're doing all right! I wouldn't go crazy wondering about how much more you could be doing. That said...

I also had private loans from SLMA when I graduated. They started out at a similar rate to yours and soon were increasing until they were 9.5% at their highest. I have no doubt that they would have increased to the legal maximum of my state (20-something%) if I hadn't immediately paid them off at that point. Check the state of disbursement on your promissory note, and you can find out the legal maximum interest rate on there somewhere.

Personally, I would create an emergency fund of a few K, and then allocate all extra income to getting rid of this debt, because they *will* increase the interest rate, period; it can't get much lower than it is now, after all. And with a 40K principal, a small increase in interest will be a rather large increase in your monthly payment. It looks like you are in a good position to afford it, but I would rather just be rid of it, myself.

Another germane point: private loans are not (of course) bound by the same regulations that federally backed FFELP loans are, which means you have fewer repayment options. With a Stafford loan (for example), you are entitled to 3 years of Unemployment deferment, 3 years of Economic Hardship deferment, and at least 3 years of forbearance (some agencies will give you more forbearance by their own choice, since interest accrues during that time period and is capitalized back into the principle at the end of it; nowadays, not sure how many will let you go beyond 36 months), along with a whole slew of others that I can't remember at the moment. With private loans, these options basically don't exist. Deferments are out of the question, and forbearances are more difficult to obtain if you can't make *any* payment; they tend to expect some token amount, preferably the amount of monthly interest that accrues. Having private debt of any kind is a little dangerous, to my mind. If you ever get into a tight spot, you have fewer options. And I'm sure you know that student loan debt is *not* erased by bankruptcy, although I am not quite sure about private student loan debt now that I think of it. In any case, bankruptcy isn't as "easy" as it used to be.

tl;dr version: I advocate putting all extra income (without making yourself miserable) toward getting rid of private debt of any sort.
posted by synaesthetichaze at 2:34 PM on November 22, 2009

Thanks, all, for the tips. Good food for thought.

I think I'll indeed throw some extra income at it each month as long as I can afford it (without sacrificing all 'fun' time, my fun budget is usually 100-150 a month and I'd rather still keep that even if it means having some extra time to pay off loans - I'm not in any sort of financial crisis and expect to have emergency funds set up should anything happen to the job down the road)

I want to continue funding my Roth IRA at the same level as now, but it sounds like it might be a good idea to throw the additional $200/month I was considering at the student loans instead.

Luckily, my monthly living expenses are pretty cheap, and my new job has pretty good advancement potential, so I think it should work out OK (and I'll try not to overthink/go crazy over it ;) ).
posted by 1901gunner at 3:53 PM on November 22, 2009

The guiding thought that's informed our attempt to pay off my wife's student loans: $5 today is $6 next month. If we stay on schedule, we'll save around $8,000 over the 2 or 3 years we pay.
posted by GilloD at 4:06 PM on November 22, 2009

One thing to keep in mind is that interest student loan debt is generally tax deductible (with a few limitations). The implications of this aren't always clear, but it's something you should factor into your decision. I suppose one way to look at it is that the deduction works to mitigate any rise in interest rates. If your debt ends up at 10%, you'll have a correspondingly larger tax break -- not so much as to totally offset the increase, but enough to take some of the edge off.
posted by lex mercatoria at 4:20 PM on November 22, 2009

I think it's prudent to put extra money away to put toward paying down your debt, but don't actually make the surplus payments if you can earn greater returns in an investment account. If your variable rate is low enough, it might be worthwhile just to pay the minimum now, and put all the extra you're thinking of putting toward the debt into an investment account that will generate returns greater than the interest you are paying. Then, if/when the interest rate increases, you can liquidate the account and make one big payment on the loans with it all at once. That way, all the money you're now contemplating putting toward the debt will still pay down the debt, but (1) you'll also be able to put the excess interest (above what the loans are accruing) toward the debt, and (2) you'll have some liquid assets handy for emergencies/contingencies.

But if your loan is accruing interest at a rate higher than any returns you could get in a short-term investment account (net of fees, naturally), then just pay the debt.
posted by dilettanti at 4:55 PM on November 22, 2009

I will give support to synaesthetichaze because that is pretty much what I did. I graduated with around 35K of student loans (some subsidized, but most not) in 2004 and as of 1 Dec I will be completely debt free.... there is light at the end of the tunnel!

I basically followed a plan by Dave Ramsey - he's a Christian financial adviser - but provides what I think is a damn good way to get out of debt. Get the emergency fund (1k or so), pay off your debt as fast as possible, establish 3-4 months of emergency savings, then really pour on the investments.

With respect to interests rates they are damn near zero and while they're expected to stay low for a while they really have no where to go but up (this taken from my casual reading of financial news not my own future ball of finance ;)

Good luck!
posted by aggienfo at 6:05 PM on November 22, 2009

Interest rates will go up in the future but you don't know how soon or by how much. I don't have the numbers handy, but I believe ~10 years ago people were already saying interest rates have nowhere to go but up.

Dilettanti is right that it is worth considering the alternatives to paying down your loans, as long as you're using relatively conservative choices (bond funds, CDs, etc) for this part of your portfolio.

Don't forget that if you choose not to contribute your $5k into the Roth IRA in a given year, you can't make it up later on. I wouldn't forgo the opportunity to increase the tax-free portion of your portfolio.
posted by Fin Azvandi at 12:50 PM on November 23, 2009