By Joseph Reinke, CFA
When I speak to recent graduates about their student loan grace period, I often hear two very different answers. The first, "I want to start paying my student loans immediately to save money." The second, "I do not need to worry about my student loans because I'm in my grace period." Who's right? The first is somewhat correct because it depends on your goals. The second is always incorrect because you need to define and implement a repayment strategy as early as possible...and no, ignoring your student loans is not a strategy. It is a costly mistake. This article discusses 3 strategies for you to implement during your student loan grace period. They are:
- Starting A Reserve Account
- Sticking with an Easy Strategy: Pay Down & Save or
- Going with the Advanced Strategy: Invest
For those of you who prefer to watch a video, the videos below detail these strategies. For more student loan videos visit our Knowledge Center.
Starting A Reserve Account
The first answer from recent graduates about wanting to immediately begin paying off your student loans during the grace period may not always be correct: before starting to repay your loans, you first need to establish a reserve account. A reserve account is another name for a rainy day fund or an emergency fund. Having a reserve account allows you to weather financial shocks. These include changing jobs, being laid-off, having to move, etc... The question to answer is how much money do you need in reserve? As with so many other financial questions, it depends.
There are a number of factors which will help figure out how much to have in reserve. The most important are your risk tolerance and what profession you are in. If you are in an in demand profession you should be able to have a lower reserve amount because you should be able to find employment fairly easily. Risk tolerance simply means how many months of buffer you feel you need to feel comfortable should your situation change unexpectedly. This buffer is simply how long you would want to "survive" having zero income and being able to meet your monthly expenses. Typically, six to nine months should be good enough, but this is a very personal decision.
To calculate your reserve account, you must first estimate your monthly expenses that are necessities. Items such as food, utilities, rent, etc... Then determine how many months you would like saved up and multiply by your monthly expenses. For example, if your monthly expenses are $2,000 and you would like a 3 month reserve, then you would need $6,000 ($2,000 x 3). Once you have that amount saved then you can decide on pursuing the Easy Strategy or the more Advanced Strategy discussed below.
Easy Strategy: Pay Down & Save
If you already have a reserve account then you need to either start making payments or invest. The easy decision is to pay down your loans. This will save you money and get you out of debt sooner. To illustrate how much you would save I will illustrate with an example. This example also illustrates why deferring "just because you can" is a (very) costly strategy. We will make the following assumptions:
- The loan is 10 years
- Student loan grace period of 6 months
- $100,000 loan balance
- 100% of the loan is unsubsidized
- The loan has a 6.85% interest rate
If you deferred your loan during the grace period, it would accrue $3,425 in interest. After the six month student loan grace period ends the interest is capitalized. This means that this amount is added to your loan balance and your new principal balance is $103,425. That is the principal amount that is charged interest during your repayment period. Over your ten year repayment period, you would pay a cumulative amount of $143,144.
To compare, let's assume you were actually working during your student loan grace period, you had a reserve account, and you could afford to make payments so you started repaying your loans immediately upon graduating. Your cumulative payment amount over the life of the loan would be $138,404. In other words, not deferring during your grace period would save you $4,739.
To those that say they don't need to think about their loans during the student loan grace period, you just costs yourself a decent amount of money. To make things worse...if you invested that $4,739 in a retirement account for thirty years at a 5% annual return you would have $21,172.
Advanced Strategy: Invest
For those of you that want a more "advanced" strategy then the following analysis must be performed. In this scenario, you can now consider either 1) paying down your debt or 2) keep the money and invest it instead.
Using the above example, if you do not make payments during the student loan grace period, then it costs you $3,425 during those six months in deferred interest. You then have to ask yourself, "If I save that $3,425 during those six months and invest it for ten years, what annual rate of return would I need to achieve over that period to end up "ahead"?" This annual rate of return is called a break-even rate of return.
To calculate this break-even rate of return you need to consider the following:
- Per our example, not making payments during the student loan grace period would generate $3,425 in deferred interest.
- Per our example, deferring during the grace period would end up costing you $4,739 over the ten year repayment period.
The question to then answer is, "If I invested the $3,425 for ten years, what annual rate of return would I have to achieve to grow this amount to $4,739?" The answer is 3.25%.
That means if you think you could earn over 3.25% during the ten year period, it would make sense for you to defer during your student loan grace period and invest.
There is one caveat to this number however: that 3.25% would be a risk-free rate of return. If you think you can earn 6%-8% by investing in the stock market, you have to remember, there is risk in those returns. This doesn't change the analysis but is another factor to be aware of.
If you would like us to apply the calculations for your specific scenario, please contact us and one of our FitBUX Coaches will get back to you. As always, if you have questions or other topics you would like us to cover, drop us a note in the comment section at the bottom of the page.