Should You Refinance Your Student Loans?
Obviously not now with federal student loan interest rates at 0% until September 30, 2021. This gives borrowers flexibility on how to manage their loan balance. Will 0% continue after September 30th? Did you take advantage and knock out large chunks of your loans, or continue to pay the minimum and put your money in other places to grow your net worth?
What you choose to do should be related to your retirement goals. Do you have retirement goals? Are you on pace to meet them? Do you know how much you actually need to retire?
Eventually the loan interest will come back, then what? I’m partial because I did this (pre-pandemic), but I think the answer is to refinance. I’ll explain the reason why I did, and discuss pros and cons of some scenarios on what can be done while rates are 0%.
So, Why Refinance?
The average market return on investments is 7%. For most of you, this is your 401k/403b and IRAs. The average student loan interest rate is 5.8%, which I’ll round to 6% for ease of arithmetic. So, in a given year, if you invest $100, you will earn $7, and if you borrow $100, it will cost you $6. Net gain, 1%, or $1. We could break out the actual financial calculation to be more precise, but that is essentially a wash. And when you factor in inflation, you are actually losing money.
If you need a more concrete example, imagine you run a Hand Grenade stand on Bourbon Street. A customer orders 5 Hand Grenades. As you turn around to make them, the guy takes a bunch of money out of your tip jar. You charge him, and he pays with the money from the tip jar.
The only way to earn money on your investments is to invest a greater amount of money per month than your loan payment. It would probably have to be at least 50% more to break even, and 100% more for a positive return. To add real numbers to that, if you have a $600 loan payment, you’d need to invest $900 to break even, and about $1200 to actually earn money on your investments. At the 1:1 ratio, you’ll see your investment portfolio amount increase, but you’re losing the same amount of money every month in interest.
I would bet that most borrowers ARE NOT even at that 1:1 ratio. So, you are spending more in interest than you are earning on investments.
Based on those numbers of loan payment + investments two paragraphs up, that’s $1500-1800/month. This is likely a very large portion of a single PT’s monthly earnings, especially when you add in things like rent/mortgage, car payments, and other bills that you have to pay. The really only way to make this feasible is to 1) have a substantially higher than average salary (private job, side income), 2) dual income, NOT dual loans, or 3) live like a monk. If you can do all three, go for it, but that isn’t practical for everyone.
If you have credit card debt and a car loan, just go ahead and proceed to #3 and pay it all down now.
A popular thing right now is the Public Student Loan Forgiveness (PSLF) program. The benefit to this program is it gives borrows breathing room on a monthly basis with low payments (likely coupled with an income based repayment plan) and gives a light at the end of the tunnel. The thing not talked about is the cost of present expenses eating into future earnings unless you are able to invest at least double the amount of loan payments. This likely isn’t the case as you wouldn’t have chosen income based repayment.
Obviously, continue to participate in this program if you feel it fits your financial goals, just don’t go into it with your eyes closed. Understand what you are giving up as a participant. At that 1:1 ratio, I’m LOSING more money that I’m earning.
Additionally, ensure your payments are at least covering the interest expense per month. Otherwise, your loan value will increase every year, and if something were to happen to the program or your eligibility, you’d end up owing MORE money.
What Are the Options?
- Do nothing. This is what most people do. Start working, make payments, one day you will be done. I’d lump the PSLF option under this category. You have to do a little more than nothing, but remember what it actually costs you.
- Aggressively pay down loans. This reduces your interest paid, as well as just lifts the burden from your shoulders. You may have to increase your income with some side gig and/or reduce your expenses, but the increased monthly cash flow you get from paying down debt is likely LARGER than any raise you’d ever get from your job. This pay raise works with all debt – instant pay raise.
- Refinance. This does give you a higher monthly payment, so that is a negative. The best way to combat that is to take advantage of the 0% interest and aggressively pay down your loan balance. Again, you may need to increase your income and/or reduce your expenses. Refinancing will increase the spread between your investment returns and interest expense, so you have a better chance at actually increasing your net worth instead of paying someone to take money from you.
I’m partial to #3, since that is what I did. Had i not done it prior to 0% interest rates, I’d be doing #2 + #3.
The biggest take away from this analysis isn’t to refinance or not, but to highlight a more effective way to look at your finances. Are you paying more in interest to borrow money than you are earning in your investments. If you are, you could consider that an emergency. If you were a business, you’d likely go out of business. You need to increase cash flow and/or decrease expense.
You may run the numbers, and decide that it just won’t work for you, and that’s fine, as long as you know the PROS and CONS of your decision. Just don’t go into the decision completely blind to what is actually happening behind the scenes.
3FN 